Canadian Finance Blog

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The Market Isn’t On Sale… Yet Posted: 11 Aug 2011 02:00 AM PDT It’s Monday night as I write this post, and I, like many of you, have watched thousands of dollars evaporate from our investment accounts over the past couple weeks. The worst of all came on Monday, with the S&P 500 down 6.66%, causing every market pundit to make the same bad joke about the devil making the market go down. Watching market coverage is like watching a train wreck. You want to look away, but you just can’t pry your eyes away from the carnage. This is not a fun time to be an investor. As what happens every time the markets sell off, all the financial talking heads start telling about how the market is on sale. You buy steak when it’s on sale, so why wouldn’t you buy stocks when they’re on sale too? After all, the goal of every investor is to buy low and sell high, so buying during market dips would be a good thing, right? Then all there’s left to do is to hold until the stock market inevitably goes back up. If it’s so easy, why doesn’t everyone do it? As I write this, the S&P 500 is at 1119 and change. Just two weeks ago the S&P 500 traded above 1340. A 16% percent decline in just 2 weeks is a pretty steep sell off, especially in such a short period of time. But what if the market was overvalued at 1340? How do we tell if the market is overvalued anyway? Trying to figure out the fair value of the market is incredibly complex. Various market participants have different motivations, all of which affect the valuation of the whole market. Some people invest only in dividend stocks. Others chase high growth names with little in actual earnings but loads of potential. And still others try to buy contrarian stocks with cloudy futures but strong balance sheets. Things like interest rates and general economic sentiment play an important role as well. The point of all this? Since no two investors are exactly alike, attempting to figure out a fair value for the whole stock market is just too complicated for us mere mortals. The best we can do is look at the market’s price to earnings ratio (abbreviated p/e) and compare it to historical values. From there we have a rough idea of whether the stock market is cheap or expensive, or somewhere in between. We know the market’s price (that’s 1119) and this site gives us the earnings for all the companies in the index. The most recent measure of S&P 500 earnings is 82.13. Divide the two figures and we get a current S&P 500 p/e ratio of 13.6. Does a p/e ratio of 13.6 represent a good value? Well, sort of. From a historical perspective, it’s around an average value. I tried to find more precise numbers, but my crack research 93 second Google search turned up empty. That means that if you were to pick a random time in history to buy the market, chances are you’d pick a market that’s at the same value as it is now. That’s okay, but it’s hardly buying low. The last time the market traded at 1119 was back in… August 2010. If you were even more patient during that market sell-off, you could have bought the S&P 500 at levels comfortably below 1100. The index bottomed at around 1050 during the month. Many of the same economic headwinds plagued the economy then. S&P earnings were… about the same. How many people were clamouring about a market sale back then? If you weren’t positive a year ago, why are you positive now? I’m not saying that you shouldn’t buy stocks at these levels. There are all sorts of stocks that look compelling at these prices. The market as a whole though, just looks okay. Traders are increasingly concerned by all sorts of things. There’s an increased risk of a brand new recession. European government debts are a mess. The United States needed a real solution for their debt problem, and they failed to deliver. Unemployment in the U.S. continues to be stubbornly high. Companies are sitting on mountains of cash on their balance sheets, since they can’t find places to invest it. There’s all these headwinds, and you’re going to back up the truck to pick up equities? By the time this gets published, the market could be well on its way to recovery, and all the doom and gloom from the previous paragraph may seem unimportant. You might have missed the boat on buying this correction altogether. I seriously doubt it though. Rather than load up early into the correction, nibble a bit. Buy a little this week and a little next. Stay patient and keep buying as long as the market is going down. And please, don’t sell anything. That’s just silly. I’ll leave you with one thought about the fallacy of looking at the p/e ratio of the S&P 500. At the end of 2008 when the S&P 500 was trading at 903, guess what the p/e ratio was? The index earned 65.39, giving us a ratio of… 13.8. You’d be sitting quite well if you would have bought then, even after the recent market crash. Valuing the market is hard, that’s why you shouldn’t invest all your cash at once. Related Posts: What Is A Price To Earnings Ratio (P/E Ratio)? What Is A Price To Book Ratio (P/B Ratio)? The 1929 Stock Market Crash The Market Isn’t On Sale… Yet originally appeared on Canadian Finance Blog on August 11, 2011.

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