That is what a priest said to me last night at a dinner before mass in west Baltimore. He told me he was thinking about investing, now that everything seemed to be humming right along. The only key to success, Father told me proudly, is diversification. “As long as you are diversified, you should be OK.”

I cringed when he uttered those words. Warren Buffett, John Templeton and every other billionaire investor alive today would be appalled! But this priest is like 99% of all investors in America. They don’t get excited about stocks until the market is making new all-time highs.

Pour souls.

In his weekly commentary, Dr. John Hussman noted that “The market climate in stocks remained characterized by unfavorable valuations and moderately favorable market action.” He went on to explain that since the start of this recent bull run, stocks have already gained a full 85.1% since their 2002 lows.

If the stock market were to close up shop today, this current rally would be the third most profitable run since 1947. But the stock market isn’t going to close up shop anytime soon. And more than likely, the average investor will not be 85% richer a year from now. Not even close.

What the average investor fails to ever understand is what happens after a large rally. Stocks fall — usually a lot.

Hussman examined every major market rally from 1947 to today. First, he measured how much stocks advanced at the top of every bull run. Second, he calculated their returns after a full market cycle — in other words, once the bottom fell out. And third, he noted the P/E of the market at its low and high throughout each cycle. For instance…

Between June 10, 1949, and July 27, 1956, stocks rose vigorously. At the beginning of the rally, stocks traded for just 5.8 times earnings. They were cheap and ripe for the picking. After a 434.4% rise (marking the peak of the rally), stocks traded for a much loftier 13.3 times earnings. It is at that point that everyone and his uncle (or priest) was giddy with greed. And of course, that is about the time that stocks sold off.

By the end of the full market cycle, stocks were only up 354.1% (a far cry from the 434.4% marking the peak). And a lot of people — all of those who invested at the top — lost more than their shirts.

More recently, you can look to the rally from 1990-1998. At the beginning of this bull run, stocks traded for 11.3 times earnings. While they were not as cheap as in 1949, they were still attractive on a historical basis. And slowly but surely, investors started to jump in. By the rally’s peak, stocks were up 374% and trading for 28 times earnings. It was at this point that the fools jumped in and the bear came a-calling…

By the end of the market cycle, the total gains were 244.8%, not 374%. And once again, a lot of people lost a lot of money despite the overall bullish trend.

Now fast-forward to today.

Since Oct. 4, 2002, stocks have shot up 85%. As I said earlier, if stocks simply stopped trading today and investors walked away with their gains, this would be the third most lucrative stock market rally in the last 60 years. But no rally is without a corresponding fallout — this one included.

Unlike all previous rallies, stocks were not cheap at the beginning of the bull cycle. The average stock traded for 15.3 times earnings in late 2002. The last time stocks were this expensive at the beginning of a cycle was in 1987. We all know what happened then…in a single day, the stock market lost 20%.

Folks, a fall is coming. I guarantee that. All the signs are there.

Corporate earnings growth is at an all-time high — an unsustainable high at that. Valuations, while not super expensive, are certainly not cheap, either. The average company on the S&P 500 currently trades for 20.9 times earnings. And the average small-cap stock in the Russell 2000 (excluding those that don’t have earnings!) trades for 19.7 times earnings.

Finally, as I have preached for the last six months, the stocks that average investors are buying these days are garbage. Here’s how I know:

I created two screens several months ago. The first screen is what I call my “good stocks” screen. It looks for small-cap companies on the NYSE that trade for (or have):

• 15 times earnings or less
• 1.5 times book value or less
• 1.5 times sales or less
• Positive free cash flow
• Revenue growth
• Net income growth.

Who can argue that cash flow, earnings and sales growth are not good? Yet the 17 “good” stocks that fit the bill are up only an average of 6.1% over the last year.

The second screen I created is called my “crap” stock screen. It searches out the worst of the worst. Namely, small caps on the NYSE that trade for (or have):

• Minute sales growth and no earnings to speak of
• No free cash flow
• 2 times book value or more.

Turns out there are 19 crap stocks on the NYSE right now. And guess what? They are up an average of 51% over the last year — nearly nine times better than the 17 fundamentally sound stocks. What does this tell you about today’s market?

It says people who are buying stocks are chasing the crap companies — those with no earnings, zero FCF, barely any sales growth and lofty valuations to top it all off.

When stocks like this are leading the way, it is only a matter of time before the grizzly stock market bear hunts you down. As Hussman writes:

“With stocks still near their recent highs, I think it’s useful to remember the tendency of bull markets to surrender large portions of their gains over the full market cycle. Without that understanding, investors are vulnerable to the temptation to ‘chase’ returns in what is already a richly valued, aged bull market advance, where recession risks continue to gradually increase.”

Now is not the time to be chasing crap stocks. And now is not the time to blindly invest just because stocks are on a roll — even if you are a priest. They don’t always “keep making money.” Just wait, you’ll see.

Regards,
James
November 14, 2006

P.S.: While thousands of stocks are not worth investing in now, there are two that will likely make investors 19 times richer (relative to the overall market) in the next six months. One is a $3 gold stock that is about to increase production capacity 150% in the next quarter. And the second is a $10 stock with the technology to turn millions of tons of worthless coal into a high-energy, high-priced commodity.

Small-Cap Market Highs was originally featured in the Penny Sleuth.