A stable, peaceful world requires a stable world financial system, but the exponentially growing sovereign debt in Washington, Europe, and around the world indicates that the world financial system is anything but stable.

Wall Street is as unstable as Washington. Most investors today are no different from drunken gamblers at roulette tables in Las Vegas. When they aren’t playing, they’re desperate and depressed. When they make money, they experience a burst of endorphins that keep keeps them happy for hours. When they lose money, they obsessively double their bets. Brokers have the best of all worlds, since they get to do all of that with other people’s money, and then collect fat commissions.

As I always like to point out, mainstream economists didn’t predict or explain the tech bubble, or why it occurred in 1995 instead of 1985 or 2005. They didn’t predict and can’t explain the real estate bubble, the credit bubble, the credit freeze, the financial crisis, or the worldwide trade and transportation freeze. They can’t explain what’s happening today, and they have no idea what’s coming next year.

For those investors who wish to make stock purchases based on real values, there’s only one reliable measure: past earnings. And you can obtain a measure of the value of a share of stock by means of the price/earnings (P/E) ratios (also called “valuations”) — divide the current stock price by total earnings in the last year.

The average P/E ratio for the S&P 500 stocks between 1871 to 1995 was 13.91. This means that if you purchased an average share of stock, then a year later the company would have earned 1/13.91 = 7.2% of the share price.

Here’s a graph of the S&P 500 price/earnings ratio from 1871 to the present:

As you can see from this graph, the P/E ratio has really skyrocketed since 1995, much higher than its historical average at several points, and ALWAYS higher than its historical average since 1995.

The Law of Mean Reversion says that the average (mean) since 1995 also has to equal roughly 13.91, and if it doesn’t, then the average will eventually revert to its historic average. In order to do that, the P/E ratio must go BELOW 13.91 for roughly the same amount and period of time as it was ABOVE 13.91 — i.e., for 15 years.

This means that the P/E ratio must fall well below ten, and stay there for years. There are people who say “this time it’s different,” but the burden of proof is on them to explain why it’s different.

One fantasy argument that these people use is that we’re using “old data” that applied to the doddering old fools who lived years ago and didn’t even have iPhones. Well, when the 1929 crash occurred, those doddering old fools were young, and were giving similar reasons why “this time it’s different.”

In fact, as you can see from the graph, the P/E ratio was as low as 6.79 very recently — in 1980. If it can fall to 6.79 in 1980, then it can certainly do so again today, and anyone who thinks otherwise is a fool.

Claiming “this time it’s different” is a fantasy. Just one look at that graph will tell you that we’re headed for the biggest crash in history, much larger than the 1930s crash. This is a mathematical certainty.

When will this crash occur? It’s impossible to predict, of course, but here’s one way to look at it:

Notice that the three points that I labeled as lows (5.31, 5.82 and 6.79) occurred at 31-year intervals. (But there’s nothing like that in 1887, so this may be completely wrong.) So we have to consider the possibility that there’s some kind of as-yet not understood 31-year cycle in price-earnings ratios. With only three data points, it’s hard to be anywhere near certain. However, if the 31-year cycle holds, then the next low will be in 2011.

Why the Law of Mean Reversion works

The average financial “expert” doesn’t consider any historical data relevant. Something that I hear all the time on CNBC or Bloomberg TV is that a stock is “oversold, because its price is lower than the 200 day moving average.” In other words, to these “experts,” nothing that occurred more than 200 days ago is even relevant to the stock price.

The very high values of the P/E index since 1995 indicate that we’ve been in a huge bubble. A bubble does permanent harm to an economy, and that harm lasts much longer than 200 days. In fact, a bubble can be compared to a poison that harms every nook and cranny of the economy for a long time.

Let’s take the obvious example of the real estate bubble. When that crashed, it obviously affected things a lot longer than 200 days. In fact, the effects today are far from over. The overall foreclosure rate is still increasing. The shadow inventory is so large that even mainstream forecasters are saying that prices will be falling for years. That’s an obvious example of how a bubble has longer effects than 200 days.

Another obvious example is the level of personal debt. During a bubble, there’s plenty of money available in the form of debt, and so people go deeply into debt, expecting that there’ll be more money (credit) in the future to pay off the old debt. At some point, when the credit bubble crashes, and there’s no more debt money available, people have to start paying off their debts, and that can take years.

The same kind of thing is true for every business. Businesses borrow a great deal of money during a bubble, and use the money to hire new employees. When they can’t borrow anymore, they lay employees off, and don’t hire any more. This creates joblessness that lasts for years.

There’s another aspect that applies to business. During a bubble, the world looks different than it does after the bubble bursts. In the bubble world, no expense is spared for glamour, with the result that businesses spend their resources on developing the labor and infrastructure to develop and manufacture products that only interest consumers during the bubble. Once the bubble ends, these businesses turn out to have the wrong kinds of employees with the wrong kinds of skills and the wrong kinds of infrastructure. Years are required for the business to figure out what the correct products should be, and to hire employees with the right skills. In the meantime, many of them go out of business.

Every person and business in the country is affected by the bubble. When the bubble ends, it takes many years to pay off debts and restructure businesses. During this time, the P/E average is much lower than it would have been if there had been no bubble.

The auto industry is an obvious example of this. During the bubble, people traded in their cars for new models more often than necessary, and they chose their new cars for prestige value. Large SUVs were the norm. Once the bubble burst, the market shifted away from SUVs, and people held on to their cars much longer, resulting in significant problems for the industry.

The poison that filled every corner of the economy, starting in 1995, was debt. Debt filled the business economy, debt filled the consumer economy, and debt filled the government economy — in America, in Europe, in China, and elsewhere. The poison created consumer products, created jobs, and created a risk-seeking population. It takes as many years to remove the poison as it did to create it.

One obvious sign of this is that trillions of dollars of “toxic assets” are still in financial portfolios around the world at nominal value — without having been “marked to market.” This “deleveraging” process has already taken several years and has hardly begun. It will take much longer than 200 days.

That’s why the Law of Mean Reversion works. Don’t blame me. I didn’t make up the Law of Mean Reversion. I’m only telling you what it says.

Attempts to cheat on the price/earnings ratio

When the Great Depression survivors (GI and Silent generations) were running things, they were very risk-averse and very careful with their investments. The P/E ratio was one of their main tools.

When the Silents finally retired in the 1990s, and the Boomers took over in senior management positions, the dot-com bubble began in 1995 (as well as the global real estate bubble).

Since the price/earnings ratios were suddenly out of whack, financial “experts” came up with several alternative ways to compute the P/E ratio to justify the bubble prices.

A common trick is to compute the P/E ratio using bloated earnings estimates for the following year (called “forward earnings”). By using bloated earnings values, the P/E ratio is lower. History has shown that earnings estimates by analysts are overstated to the point of absurdity. (See The incompetence of financial analysts.)

Another trick was the “The Rule of 20,” thought up in the late 1990s in order to justify purchasing overpriced stocks during the dot-com bubble, by trying to prove that the average P/E ratio should be 20, rather than 14. People who followed this advice lost money in the Nasdaq crash.

More recently, one commonly used stunt is to use “operating earnings” rather than “real earnings.” Operating earnings are computed by taking real earnings and adding back in any “one-time losses.” In this fantasy, practically anything can count as a one-time loss. In fact, the Wall Street Journal was using operating earnings without even telling anyone, until my web site and other web sites embarassed them into using real earnings. (See “Wall Street Journal sharply revises its fantasy price/earnings computations.”)

At this point, you rarely even hear about P/E earnings or valuations used much, or if there’s a financial “expert” on tv who refers to valuations, he pulls a number (like 10) out of the air, and announces that stocks are underpriced. It’s absolutely incredible.

The same factors that led to the 2007 credit crunch still exist today, only they’re much worse. Banks that were too big to fail are much bigger. Banksters that screwed and defrauded their customers and clients, so they could pay themselves million dollar bonuses, are still doing so.

From the point of view of Generational Dynamics, the financial crisis has only begun. Once the real crisis occurs, and tens of millions of people lose their jobs and face starvation, a lot of the world will blame their neighbors and the United States. The result won’t be pretty.