Have you ever bought a pair of pants for your child or grandchild that were too big? It’s a common occurrence, and when it happens you basically have two options: One, you can throw the pants in the wash and try to shrink them. Or two, you can just sit back knowing that child or grandchild will eventually grow into them. In essence, this same phenomenon applies when the price of stocks get overinflated in relationship to annual corporate profits, and if you can learn to recognize when it’s happening, that knowledge can go a long way toward helping you make smart, safe savings and investment decisions.
I first observed this phenomenon back in 1998. What I was seeing, and what was starting to worry me, was that the overall price of stocks in the market was becoming overinflated – like a baggy pair of pants – relative to actual corporate profits. I understood from my knowledge of market history and my grasp of the basic financial ratios that one of two things had to happen to correct this growing imbalance: that overall stock prices had to shrink by 75 percent, resulting in a Dow Jones Industrial average below 3,000, or we had to slip into a significant and prolonged period of market volatility while we waited for corporate profits to grow into these baggy price levels.
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