Identifying Market Inflection Points
Russell Napier, ASIP
Author and Consultant Global Macro Strategist
CLSA Asia-Pacific Markets
Dalkeith, Midlothian, United Kingdom
The outlook for the U.S. stock market looks favorable for the next two years. But the final
phase of the bear market will begin with a collapse in U.S. Treasuries. Commodity prices,
bonds, and Treasury Inflation-Protected Securities are already pointing toward a material
equity market rally, even as historical trends indicate that equity valuations and turnover
ratios are still too high.
I n 2001, I went to the Edinburgh Business School
and proposed establishing a course called the
“Practical History of Financial Markets.” Part of its
purpose would be to counterbalance the efficient
markets hypothesis, which asserts that all available
information is in the price of an asset. The dean liked
the intent and content of the course but hated the
title. He said that business school students would
not pay good money for a history lesson. Fortu-
nately for me, they were more interested than he
suspected and interest is growing rapidly.
The Value of Studying Financial
History
One reason financial history has value is that it
contains all available information, just as prices do.
A second reason is succinctly expressed in a quote
from James Grant, who wrote, “Progress is cumula-
tive in science and engineering but cyclical in
finance” (1994). After all, physicists do not have to
repeat the experiments of Madame Curie. They
have learned from those experiments.
In financial history, however, we keep repeat-
ing the same experiments. We do so because greed
and fear are always inherent in us. Much of this
repetition is explained by behavioral finance, a field
that received powerful recognition when Daniel
Kahneman was awarded a Nobel Prize in Econom-
ics in 2002. The Nobel Prize committee cited Kah-
neman “. . . for having integrated insights from
This presentation comes from the 2009 CFA Institute Annual Confer-
ence held in Orlando, Florida, on 26–29 April 2009.
©2009 CFA Institute  cfa pubs .org
psychological research into economic science, espe-
cially concerning human judgment and decision
making under uncertainty.”
The study of financial history is, if nothing else,
an investigation into human judgment and decision
making under uncertainty. Because every decision
ever made in financial markets was made under
uncertainty, in that regard, conditions were no dif-
ferent in 1920 than they are today. Thus, by studying
financial history, we understand better the pro-
cesses involved in finance.
By examining financial history, we are taking a
radical approach to investment, even if it should not
be considered as such. Studying financial history
simply means trying to understand markets by
examining how they have actually worked. What
makes it radical is that the study of financial markets
is dominated by academics who view the market
through the prism of how markets should work. But
when we study financial history, we are looking at
the way the market actually was and the way it has
developed and changed. We can enter the discus-
sion without preconceived assumptions.
Furthermore, a study of financial history
reminds us that our ancestors were not stupid. One
of the thoughts I hear far too often is that we are
smarter today than investors in the past were and
that markets today are far more developed today
than those in the past. Yet, I know from even a
cursory study of financial history that in 1800, intel-
ligent investors were outperforming in a highly
competitive stock market. They understood it bet-
ter than their contemporaries did, and they made
more money. In that respect, the situation was no
DECEMBER 2009  27
CFA Institute Conference Proceedings Quarterly
different then than it is today. But today, we have
decided to forget these financial pioneers by
assuming that they understood nothing. I suggest
that we reclaim some of the pre-Markowitz (pre-
1952) wisdom of our investing ancestors, which
exists in the pages of financial history but has been
dismissed in recent times.
Finally, to really understand a market, one must
spend time in its company. Unfortunately, we have
all had an opportunity to do just that for the past year
or so, and we should all have learned something
about bear markets. But we can learn even more by
studying previous bear markets as well. Learning on
the job is particularly expensive for investment pro-
fessionals, but another way is available.
I have found that most financial history books
end when a market crashes, when people go bank-
rupt and start jumping from the windows of tall
buildings. That is, they end just as the bear market
is ending. Few books cover the more mundane
period that follows, largely because many financial
histories are written by journalists who are inter-
ested in the drama of the market, not its long-term
behavior. But investors ought to be precisely inter-
ested in just such behavior. Therefore, when I wrote
Anatomy of the Bear (Napier 2007), I examined not
just bear markets but the bottom of bear markets
because it is at market bottoms that the most attrac-
tive return possibilities can be found. More specifi-
cally, I focused on the bottoms of the four most
profound bear markets: August 1921, July 1932,
June 1949, and August 1982.
Importance of the q and CAPE
Ratios
In their book Valuing Wall Street, Andrew Smithers
and Stephen Wright (2000) examined every mea-
sure of equity valuation for the United States going
back as far as 1800. They studied yield ratios, yield
gaps, price-to-book ratios, dividend yields, cash
flow yields—everything that seemed pertinent.
They then evaluated these measures as predictors
of future returns and identified two measures of
valuation for U.S. equities that are predictive of
long-term returns: Tobin’s q ratio and the cyclically
adjusted price-to-earnings (CAPE) ratio. The q ratio
measures the price of equities relative to the
replacement value of assets, and the CAPE ratio
measures the price of equities relative to 10 years of
rolling average earnings. One ratio measures value
relative to assets, and the other ratio measures value
relative to earnings, but both have produced good
indications of future prices for long-term investors.
28  DECEMBER 2009
Smithers and Wright measured the ability of
these valuation measures to predict future prices by
constructing a measure of future returns that
includes the average of 40 future returns. The aver-
age return is constructed from 40 individual returns
from time horizons ranging from 1 to 40 years into
the future. The future return of the average of these
time horizons provides a “hindsight value” over a 40-
year horizon. They then overlaid hindsight value
with every valuation metric available for U.S. equi-
ties, and they found that the CAPE and q ratios would
have led investors to sell prior to poor returns and
buy prior to good returns as illustrated in Figure 1.
In 1921, 1932, 1949, and 1982, the U.S. equities
market was at its lowest for the CAPE and q ratios,
which is why I have used these four bottoms in my
own study. The approach is value driven and prac-
tical; it is not academic. These are the times I am
interested in because they have the best subsequent
returns. After identifying these four remarkably
similar lows for the CAPE and q ratios during the
last 100 years, I then read every copy of the Wall
Street Journal for two months before and two
months after each bottom, which comes to 16
months of bear market bottoms and about 70,000
articles in the Wall Street Journal . Thus, I was able
to analyze the turning points in these bear markets
from not only the point of view of hindsight but
also from that of contemporary opinions, whether
they turned out to be right or wrong.
In Figure 2 , the CAPE ratio shows the four
bottoms I identified (i.e., 1921, 1932, 1949, and 1982)
for my study. It is important to note, however, that
the CAPE ratio tells us almost nothing about where
the stock market will be next year. But unfortu-
nately, observers are using it as a short-term market
predictor. Some are currently using the CAPE ratio
to predict a sharp decline in equities based on the
CAPE ratio’s current level. But this is not a valid use.
As Figure 2 shows, the CAPE ratio in 2003 was in
the vicinity of its highs in 1966, 1929, and 1901,
suggesting that the stock market in 2003 was over-
valued. And yet from that point, stocks doubled. So,
the CAPE ratio did not help anyone who was look-
ing for short-term returns in 2003. But for those
investing for the long term, avoiding U.S. equities
in 2003 was not a bad idea at all.
If you think about how the q ratio drives capital
creation, it becomes clear how it can be an effective
measure of valuation only over the long term. Con-
sider what it means to have a q ratio equal to 2. In
this case, the board of a company has an incentive
to take $1 of cash flow and invest it in physical
capital because the moment it does, the market val-
ues it at $2. But if the q ratio is 0.7, the company
©2009 CFA Institute  cfa pubs .org
 Identifying Market Inflection Points

Figure 1. Hindsight Value and q Ratio for the Equities Market, 1900–1980
Ratio
3.0

2.5

2.0 Hindsight Value

q Ratio vs. Average

1.5

1.0

0.5

0
1900 10 20 30 40 50 60 70

Note: “Average” is the average q ratio since 1900.

Sources: Smithers & Co. and CLSA Asia-Pacific Markets.

Figure 2. CAPE Ratio for Equities Market, January 1881–January 2009

Cyclically Adjusted P/E
50

45

40

35

30

25

20

15

10

0
1881 97 1913 29 45 61 77 93 2009

should probably make a different decision. Thus,
the ratio is much more than an indicator of whether
equities are cheap or expensive. The q ratio becomes
part of a bigger capital arbitrage that has to happen
before the bottom of a market can be reached. Only
when the q ratio goes that low can physical capital
creation be staunched and the supply and demand
for capital be brought back into balance.
Drivers of Bear Markets
If there is one strategic conclusion in my book, it is
that all bear markets are driven by disturbances to
the general price level, whether it is inflation or
deflation. Most bear markets are very long. For
example, if an investor bought equities in 1901 at a
time of high valuations, that valuation would not
reach its low for 20 years (i.e., in 1921). Consider
1937, when equities were again very expensive; they
reached a new low in 1942 and were almost back to
the same low as late as 1949. Similarly, between the
high valuation of 1966 and the low of 1982 is 16
years. The current market peaked in 2000, but as of
2009, its valuation has probably still not hit the low
valuations seen in 1921, 1932, 1949, and 1982.

©2009 CFA Institute  cfa pubs .org DECEMBER 2009  29

CFA Institute Conference Proceedings Quarterly
All of the peaks of valuation are driven by the
same illusion. It is called the new economy, which
is defined by low inflation and high growth. In
terms of valuation, it is defined by a low discount
rate and a high growth rate that leads to peaks in
valuation, such as those in 1901, 1929, 1937, 1966,
and 2000. Such peaks are illusions that must be
shattered, and they are usually shattered by infla-
tion. During the current cycle, we have experienced
two runs of inflation: 1999–2001 and 2004–2008. The
belief in the new economy, with its sustainably high
growth and sustainably low interest rates, is usually
associated with a technological breakthrough that
makes the combination sustainable this time.
When starting from conditions of a new econ-
omy, disturbances to the general price level always
bring valuations down. For example, the United
States experienced an outbreak of inflation in 1917
when it entered World War I. Inflation reached a
peak in 1920, at which time it ended with a defla-
tionary episode. Long bear markets begin with
inflation that shatters the new economy illusion and
usually end with deflation or a deflationary risk as
central banks finally overreact to inflation.
Figure 3 shows the DJIA plotted against the
general price level for the years 1916–1948. The
years from 1929 to 1932 demonstrate another way
to destroy the myth of a new economy. During that
time, the DJIA collapsed, but so did the overall price
level. This period demonstrated that deflation also
can undo the concept of a new economy. During this
period, the risk-free rate did not go up, but the
Figure 3. General Price Disturbances Led to Cheaper Equities, 1916–1948
DJIA
450
400
350
300
250
200
150
100
50
0 0
16 20 24 28 32
30  DECEMBER 2009
assumed growth rate of dividends collapsed. Thus,
breaking the myth of the new economy does not
need to occur through rising inflation; it can occur
through deflation. The reason 1929–1932 is different
from other episodes is because the new economy
high valuations were almost instantly undermined
by a collapse in the dividend growth rate as a result
of deflation. All the other declines in valuations
have occurred much more slowly because the rise
of inflation has dented belief in the new economy
myth much more slowly.
A key lesson is that a deflation-induced bear
market in equities ends when deflation ends or is
perceived to be ending. The reason that deflation is
so inherently bad for equities is that equities are not
really assets. Equities are the fine sliver of hope
between assets and liabilities. And deflation raises
serious questions as to the survivability of that hope.
Consider the impact that deflation has on a com-
pany’s cash flow. If the prices of its goods are falling,
the ability of a company to service the fixed cost of
its debt declines. At the same time, deflation causes
the value of a company’s assets to decline, whether
measured by market value or replacement value. If
asset value falls as the cost of debt increases, the very
existence of what is measured as equity is called into
question. When deflation arrives and equity surviv-
ability is questioned, myopic discounting sets in.
The shorter the discounting horizon for future cash
flows is, the lower the valuations for equity are. One
can see the theoretical impact on valuations if defla-
tion passes and discounting periods normalize.
Price Index
100
90
80
70
U.S. Wholesale Price Index
(right axis) 60
50
40
30
20
DJIA
(left axis) 10
36 40 44 48
©2009 CFA Institute  cfa pubs .org

Finding the Bottom of a Deflation-
Induced Bear Market
When a deflationary bear market ends, the equity
risk premium declines and with it, equities will rally,
often months before the end of an economic down-
turn becomes apparent in the data. But several indi-
cators exist that may signal the end to a period of
deflation. These indicators, which I compiled while
reading the 70,000 bear market articles in the Wall
Street Journal, include the following:
• inventory in the system is low;
• commodity prices start to stabilize;
• demand goes up at lower prices, particularly for
luxury goods or goods in structural demand;
• certainty on general price levels and valuations
increases; and
• corporate bonds rally.
Although all of these indicators may prove
valuable, I want to discuss several of them in
more detail.
Commodity Prices as a Bottom Indicator.
Of the indicators of change that I listed, the most
objective is commodity prices. In the four bear mar-
kets I studied, commodity prices bottomed almost
simultaneously with U.S. equities. Copper prices,
which have almost always been a coincident indica-
tor with equities, were particularly accurate, bot-
toming out in August 1921, June 1932, June 1949,
and June 1982. In December 2008, copper futures
dropped to about $130. As of 6 April 2009, the July
2009 copper futures contract had risen to about $195.
Figure 4. Corporate Bonds Led Equities to the Bottom, January 2002–
January 2004
DJIA (thousands)
11.0
Lehman U.S. Aggregate
10.5
DJIA
10.0 (left axis)
9.5
9.0
8.5
8.0
7.5
7.0
Jan 02 Apr 02 Jul 02 Oct 02
©2009 CFA Institute  cfa pubs .org
Identifying Market Inflection Points
The pertinent question, therefore, is whether copper
hit a decisive bottom in December 2008. If so, that is
a good sign that this bear market is over. If not, the
bear market will remain with us. Still, we need to be
alert to the possibility that at this time, copper
futures could be sending a false positive signal. One
of the reasons the price of copper futures is up is that
the government of China is buying a lot of copper,
as are other governments around the world.
Corporate Bonds as a Bottom Indicator.
Bonds, particularly corporate bonds, tend to be
good indicators of the bottom for equity markets.
Perhaps the reason is that corporate bond investors
tend to be more interested in the inflation debate
than equity investors are. My historical research
shows that when equities bottomed in August 1921,
government bonds had already bottomed in May
1920, and Baa rated corporate bonds did so in June
1921. Preceding the July 1932 equity bottom, gov-
ernment bonds bottomed in January 1932, and Baa
rated corporate bonds did so in May 1932. Similar
trends can be found for 1949 and 1982. In fact, I have
found that corporate bonds bottom even during
intermediate bear markets just before or with equi-
ties. Figure 4, which covers January 2002 to January
2004, illustrates the last equity bear market by plot-
ting the DJIA against the Lehman Brothers U.S.
Aggregate Index of Baa corporate bonds. Corporate
bonds bottomed around November 2002 and then
entered a significant rally, with equities taking a few
months to catch up. According to the National
Bond Index
118
116
Baa Corporate Bonds
(right axis) 114
112
110
108
106
104
102
100
98
96
Jan 03 Apr 03 Jul 03 Oct 03 Jan 04
DECEMBER 2009  31
CFA Institute Conference Proceedings Quarterly
Bureau of Economic Research, the economy bot-
tomed in November 2001, with corporate earnings
bottoming in March 2002. Yet, the equities market
did not really bottom until March 2003, which is
unusual because the equity market is not typically
behind the economy and reported earnings. Never-
theless, the corporate bond market had been urging
caution because of the deflation risk, which eventu-
ally passed. The continued rally in corporate bonds
in late 2002 and early 2003 was again, as it was in
1921, 1932, 1949, and 1982, a good indication that it
was time to buy equities. A rally in corporate bonds
is currently under way.
Treasury Inflation-Protected Securities as a
Bottom Indicator. Although they did not exist dur-
ing any of the great bear market bottoms, Treasury
Inflation-Protected Securities (TIPS) are the best
indicator of future inflation or deflation expectations
and should be a third objective bottom indicator,
although they are certainly not perfect. From time to
time, such as in November 2008, TIPS suffer from
restricted liquidity relative to U.S. Treasuries. As a
result, three-year TIPS appeared at that time to be
forecasting a 3.6 percent deflation annually for the
next three years. If it had occurred, it would have
translated to a more than 10 percent drop in the price
level in the United States, a decline not seen since the
Great Depression. But by April 2009, the three-year
TIPS, as shown in Table 1, were indicating a level of
inflation of 0.28 percent, which is a serious swing
from the level recorded only six months before. Nev-
ertheless, TIPS are a key indicator of inflation, and at
present, they are suggesting that things are a lot
better now than they were in November 2008.
Based on historical trends, today’s indicators
are going in the right direction. Copper is going up,
as are corporate bonds. These developments have
a lot to do with government actions, but I believe
that even in a purely market-driven system, the
Table 1. Yields on TIPS and Treasuries as of
April 2009
Expected
TIPs Treasuries Inflation/Deflation
1 year 0.68% 0.58% –0.10
2 year 1.31 0.95 –0.40
3 year 1.05 1.33 0.28
5 year 0.97 1.86 0.89
7 year 1.53 2.50 0.97
10 year 1.44 2.88 1.40
30 year 2.02 3.69 1.67
32  DECEMBER 2009
indicative prices have already made a bottom. A
number of subjective indicators are also available,
but commodities, corporate bonds, and TIPS are
the most objective and valid indicators that the
equity market has bottomed.
Developments Following Bear
Market Bottoms
The reaching of a bottom in equities creates the
possibility of a strong rebound. In the four historical
bottoms I have studied, equity returns were quite
impressive in the five years immediately following
each bottom. In fact, the biggest bull market in the
history of the United States occurred between 1932
and 1937, in the middle of the New Deal. That boom
tends to go unnoticed as economic conditions
reversed after 1937. But from 1932 to 1937, when the
New Deal was in full force, equity investors earned
record-breaking returns. They did so because the
high degree of government intervention was creat-
ing inflation in the economy. And investors, who
must work with the conditions they are given,
understandably prefer equities to government
bonds in an inflationary environment. For those
who would rather hold bonds than equities during
such a period, I can only advise that financial history
is strongly against them.
Tactical Considerations during a
Bottom
When faced with the bottom of a bear market, inves-
tors should keep a number of considerations in
mind. First, surprisingly, no lack of good news exists
at the bottom of a market. Unfortunately, the apathy
that bear markets create causes investors to ignore
the good news. For example, newspapers today
have plenty of good news, but it is not on the front
page; it is in the middle pages. The fact that the bond
market is working and corporate bonds are being
issued is good news. To find the bottom of a bear
market, investors have to look beyond the headlines.
Second, take note of daily trading volume.
Toward the end of a bear market, the market dis-
plays a tendency to decline on small volume but
increase on large volume. Sometimes, we may even
see this pattern within a single day’s trading.
Third, short positions go up strongly in the first
few weeks following a market bottom. But even as
the number of short positions increases, the market
does not fall. This situation is a confirmation that the
bear market is coming to an end. Investors with
short positions try hard every day to profit from
what they believe is a bear market rally. But at some
©2009 CFA Institute  cfa pubs .org

point, usually about four to six weeks after the
bottom has been reached, the short positions are
forced to capitulate and short positions fall sharply.
Fourth, watch for the dance of the “little bears.”
Just as mania occurs at the top of a bull market, it
can also occur at the bottom of a bear market. Sud-
denly, every investor on every street corner knows
how to make money shorting equities at the bottom.
Therefore, when the average size of short positions
starts to fall, consider it an indication that the last
holdouts are shorting stocks.
Fifth, an important technical indicator of the
bottom of the market that I am not currently
seeing—which is one of the reasons that I am con-
vinced we have not reached the final bear market
bottom—concerns volume. During a real bear mar-
ket, volume decline is much larger than market
decline. As a consequence, an equity bear market
is not over until nobody wants to invest in equities.
At its worst so far, the DJIA has declined by more
than 50 percent. And yet, everyone still wants to
invest in equities. In all the bear market bottoms I
have studied, such behavior is not indicative of a
long-term bottom.
Consider volume statistics and turnover ratios.
The turnover ratio today remains above 100 percent,
which means the average holding period of NYSE
stock is still no more than 12 months. (The turnover
ratio is found by taking the total number of shares
listed on the NYSE divided by the number traded.
A ratio of 100 percent indicates a 12-month holding
period.) At the bottom of a bear market, the holding
period is typically closer to three years, which indi-
cates a general unwillingness to participate in the
equity market. During the 1919 market peak, the
turnover ratio was 153 percent. But by the 1921
bottom, it had fallen to 59 percent. In fact, in the past,
the turnover ratio has generally steeply declined
from its bullish high. Moreover, in each of the bear
market bottoms—1921, 1932, 1949, 1982—levels of
turnover were at least half of what they are today,
which indicates to me that the markets have yet to
reach the degree of despair with respect to equities
that denotes a final bottom.
Final Stage Yet to Come
In my opinion, the most dangerous financial instru-
ment today is Treasuries because Treasuries could
bring the stock market crashing down. From my
studies, I have found that the best time to buy equi-
ties is when inflation is high but when the authori-
ties are getting control of it. The ideal situation is a
long, slow, measured disinflation such as occurred
from 1982 to 2000. That was a wonderful period for
©2009 CFA Institute  cfa pubs .org
Identifying Market Inflection Points
equities. Unfortunately, that experience convinced
many of us that the behavior during that period is
the way equities normally perform, although his-
tory indicates that equities perform like that only
during periods of disinflation. Unfortunately, that is
not the sort of period I foresee in the near future.
History also indicates that over the short term,
another attractive time for equities occurs when
inflation is close to zero but starts to rise toward 4
percent. Such a period occurred from 2003 to 2007,
during which time the stock market doubled. I
believe that a 4 percent rate of inflation and 6 percent
Treasury yield on 10-year paper represent important
inflection points in the outlook for equities because,
in the long run, equities do not perform well under
those circumstances. I believe, however, that at some
time during the next few years, the Treasury yield is
likely to head toward the 6 percent level, or inflation
is likely to head toward 4 percent. At that point, we
should all worry about a bear market in equities. In
fact, I would not be surprised if the S&P 400 does not
bottom until 2014. After all, bear markets have been
known to last from 10 to 20 years.
The key event that will lead to the fundamental
structural changes that could bring about a collapse
in Treasuries has already begun to occur. In Febru-
ary 2008, the first Baby Boomer received a U.S.
Social Security check. Following the first recipient
are more than 80 million Baby Boomers who will
also be eligible for Medicare. According to projec-
tions from the U.S. Congressional Budget Office
(CBO), the ratio of public debt to GDP in the United
States will rise until 2019, at which point the projec-
tions end. But if the projections did not end, the ratio
would continue to increase. The CBO forecast
shows that the gross U.S. public debt-to-GDP ratio
will reach World War II levels even as economic
growth returns. The fundamental structural reason
why the ratio of public debt to GDP will continue to
increase over the course of the next decade will be
the increase in Medicare and U.S. Social Security
payouts to future retirees. Moreover, because of two
highly optimistic assumptions, this forecast may
represent a best-case scenario. The CBO assumes
that the cost of government debt will not rise much
above 4 percent between now and 2019. The CBO
also assumes that the United States will not experi-
ence another recession before 2019 and thus will
experience average real growth of 3 percent
throughout this decade. But even if these assump-
tions prove to be true (which is doubtful), the United
States will still have a debt-to-GDP ratio of 80 per-
cent and rising. This reality is the prospect for the
Treasuries market.
DECEMBER 2009  33
CFA Institute Conference Proceedings Quarterly
If a supply problem exists for Treasuries, then
a demand problem also exists. When properly
judged, 2008 will go down in financial history not
as a year of financial crisis but as the year in which
40 percent of the world’s population realized they
could not keep getting rich by selling to 14 percent
of the world’s population. That realization will
shape the rest of this century. By undervaluing their
exchange rates, the formerly communist world was
able to enrich itself by selling to Europe and the
United States, but the game came to an end in 2008.
Plan B is for the producing countries to encourage
domestic consumption in their own economies.
When that switch occurs—and it is going to take
some time—those countries (China, in particular)
will stop depressing their exchange rates and accu-
mulating dollars as a reserve currency. At that
point, the percentage of Treasuries held by foreign
investors, which is currently at 53 percent, will
begin to decline. If U.S. equity valuations were to
reach their 1921, 1932, 1949, and 1982 nadirs, then
R EFERENCES
Grant, James. 1994. Money of the Mind: Borrowing and Lending in
America from the Civil War to Michael Milken. New York: Noon-
day Press.
Napier, Russell. 2007. Anatomy of the Bear: Lessons from Wall
Street’s Four Great Bottoms . Petersfield, Hampshire, U.K.:
Harriman House.
34  DECEMBER 2009
a major bear market in Treasuries would be exactly
the catalyst to produce just such valuations.
Conclusions
I can offer, based on my study of historical bear
markets and my perceptions of current conditions,
four specific conclusions:
• To reach the record lows of 1921, 1932, 1949, and
1982, U.S. equities will have to fall by 50 percent
from their current levels.
• Deflation produces record low equity valua-
tions, but prolonged deflation in today’s
economy remains unlikely
• A significant short-term rally in the equities
market is likely. Investors should watch corpo-
rate bonds, commodities (particularly copper),
and TIPS as indicators of equity market changes.
• The final stage of the equity bear market will be
driven by a bear market in Treasuries.
This article qualifies for 0.5 CE credits.
Smithers, Andrew, and Stephen Wright. 2000. Valuing Wall
Street: Protecting Wealth in Turbulent Markets . New York:
McGraw-Hill.
©2009 CFA Institute  cfa pubs .org

Question and Answer Session
Russell Napier, ASIP
Question: What is a reliable
source for q ratios?
Napier: The source is the Federal
Reserve, which has been compil-
ing the data since 1952. For pre-
1952 data, I relied on the book
Valuing Wall Street by Smithers
and Wright (2000). The reason I
use both the CAPE and q ratios is
that the q ratio has issues, particu-
larly in terms of intangible assets.
Therefore, I use them together,
watching for divergences between
the two. Furthermore, q ratios do
not exist for financials, but the
CAPE ratio includes everything in
the S&P 500 Index.
Question: Can you use the q
ratio to identify bottoms in other
markets?
Napier: The q ratio does not exist
for other markets, which is
another reason to use the CAPE
ratio. Smithers has studied Japan
and is unhappy with the results
for the q ratio there because land
is such a huge proportion of total
©2009 CFA Institute  cfa pubs .org
assets. The value of land tends to
move coincidentally with the
stock market.
Question: Does your view of
a long-term bear market in equi-
ties, especially with a collapse
of Treasuries, require another
multiyear banking crisis as
occurred in the 1930s?
Napier: The short answer is yes.
Increasing Treasury yields will
bring a depression to the United
States that will wipe out many
banks. In addition, by that time,
the dollar will already be falling,
which is different from the current
situation. In the current crisis, the
U.S. government was able to rain
down extra currency because it
could be fairly certain that it
would not depreciate the currency
because most other countries were
engaging in the same form of mon-
etary stimulus. But the next crisis
will be largely a U.S. debt crisis
triggered by particularly strong
growth in the emerging world that
will force those countries to
Q&A: Napier
revalue their exchange rates. As
bizarre as it sounds right now, the
current crisis will seem, in retro-
spect, to have been quite easy to
get out of compared with the next
one. The reason is that the U.S.
government will be unable to
apply the same policy tools next
time because the dollar will be
depreciating considerably.
Question: If that is the case, why
not simply buy and hold TIPS now
rather than buy equities?
Napier: Many ways exist to
respond to a move back toward
inflation. In the short term, inves-
tors can buy equities. TIPS, gold,
or out-of-the-money puts on Trea-
suries should also provide good
protection from inflation. Unfor-
tunately, the U.S. government will
have few policy choices other than
attempting to inflate our way out
of the next crisis. Investors, there-
fore, need to align their portfolios
for that eventuality.
DECEMBER 2009  35