This morning's column from Paul Farrell on the misleading signals P/E ratios can offer during bull markets dovetails nicely with my post from yesterday on The Questions When and What Until Then? I'm not usually a fan of Farrell's, for reasons you'll probably understand if you read the article, but he makes some excellent points about P/E ratios — and specifically the Shiller (CAPE) P/E ratios I discussed yesterday — that I would have included in yesterday's post if I'd had the information then.

To briefly review, the Shiller P/E (or CAPE, "cyclically adjusted P/E) differs from standard Price/Earnings ratios because Shiller uses the past 10 years' earnings, while a standard P/E ratio looks only at earnings over the past year. This smoothing of earnings over a longer time period often provides better insight into broad market valuation, because the standard P/E is subject to distortion when earnings have been rapidly rising or falling during the prior 12 months. The Shiller P/E smooths away the impact of those short-term changes in earnings.

Currently, the Shiller P/E seems to be THE news story everywhere. There are two reasons for this: Shiller just won the Nobel in Economics, and this Shiller P/E is showing stocks to be overvalued relative to the historic average for this measure, which feeds the "bubble" stories. What Farrell does well in his article today is point out that the Shiller P/E does do a good job of showing when the market valuation is getting high, but that it typically is way early in calling the end of bull markets. He points out that the Shiller P/E was similarly high as early as 2004 (that bull market didn't peak until Oct 2007). He doesn't explicitly state it, but the same thing happened in the mid-90s, with that bull market continuing to soar for years after reaching today's levels.

Chart from multipl.com

Admittedly, investing becomes more dangerous as market valuations get stretched late in bull markets. But valuation really doesn't offer an immediate guide as to when bull markets will end. For that, monetary policy is a much more effective signal. When rates start to tighten, that's typically the game changer. The fact that the Shiller P/E is around 25 today, well above the average of 16, tells us relatively little about the timing of the end of this bull market, considering that it ran all the way to 44 in December of 1999.

(All of this is "inside baseball" really, as we don't encourage you to try to make timing decisions about the market anyway. If you allocate part of your portfolio to Dynamic Asset Allocation as we suggest, you're getting some defensive "timing" help built right into the strategy. The difference is it isn't predictive timing of the sort Shiller P/E advocates are doing, it's trend-following which waits for the markets to actually demonstrate that it's time to step aside from stocks. That's a huge distinction.)

Look, it's not all great news that the Fed is pumping so much liquidity into the economy that stocks are soaring. I don't think it's necessarily a good thing overall that they refuse to reign in their extraordinary QE policies, which are providing the rocket fuel for this continuing bull market. We've seen before how excesses by the Fed tend to lead to painful market corrections later. But that is the hand we've been dealt. We've seen in the past that when the Fed provides significant liquidity for an extended period of time, stocks tend to soar. This time, their policies have been stronger, and lasted longer, than anything anyone has ever seen before. It seems likely — by no means guaranteed, but likely — that these extraordinary actions are likely to produce an even bigger stock market reaction than has been seen before. That's the basis of my expectation that we've got another significant leg up before this market is done, and it wouldn't shock me if the scope of that final leg up surprises us all.

That said, the bad news that goes hand-in-hand with that seemingly cheery assessment is that once this massive bull market has run its course, the next bear market is likely to be nasty. The higher they rise, the farther they fall, or some such. We saw that after the artificially-enhanced bull markets of the late-1990's and mid-2000's, and there's no reason to expect this one to be different.

One big difference between those instances and this one is we have DAA in our tool belt, whereas we didn't have any comparable protective tools available in those cases. But the takeaway from this week's trio of posts is it's probably a mistake to focus too much on that eventual bear market now. Expect to hear and read various people shouting about how overextended this market is right up to the day they are eventually proven right by the next bear market. The fact that they may have been years too early won't matter then — they'll be hailed as modern prophets who saw it coming all along. That's okay.

In the meantime, stick with your plan, expecting there's a good chance there are still substantial gains to be made between now and when this bull market ends. And gradually become mentally steeled to the fact that it will end eventually, and before it does you want to have your plan in place for surviving the next bear market. Whether that's simply renewing your dedication to sticking with your current allocations and strategies through the next bear market, or whether that means shifting more to DAA from your other strategies, etc. — be working out those details now, so you're ready when the bear does arrive.

Remember, investing always involves working with probabilities rather than certainties. So being prepared for any eventuality at any time is the goal. This whole post could be wrong and the next bear market starts tomorrow. Investing is a humbling endeavor. Whatever the market's course from here, a healthy blend of Upgrading and DAA will provide you the upside potential (via Upgrading) you want for however long this bull market continues to run, while also having downside protection already in place (via DAA) for whenever the next bear market does roll along. That's a much easier, and more effective, approach to tackling the transition from bull market to bear than any type of timing you might attempt using Shiller P/E's or any other timing device.