When to Invest — How to tell when to make Stock Purchases


When to Invest — How to tell when to make Stock Purchases with Index or Mutual Funds When to Invest What to Invest In How to tell when the Stock Market is On Sale? How do I know when stocks are cheap? How do I know when stocks are expensive? What does it mean when stocks are fairly valued?

First we started with How to Invest and disclosed that over the last 60 particularly good years the S&P500 index had delivered an annualized return rate of about 10% or 7% after inflation. The question becomes how we can do our best to insure that we get that kind of a return going forward which requires that we know why stocks achieved that rate of return. Past performance is no guarantee of future. Otherwise it would be simple to pick whatever funds had returned the best in the past.

Another thing we do not want to try is to time the stock market, we simply want to make smart allocation decisions with money we have to invest. This is in bold because it’s so important.

We want to avoid grossly overpaying perhaps purchasing bond or debt for yield in larger quantities during the times when the market is expensive and when it is cheap we wish to maximize our purchases of shares. There is a way to make an educated guess about the overall valuation of the stock market and it comes from understanding what determines each individual company’s share price. While on a day to day basis stocks can fluctuate rapidly. The general basis for a valuation of a company is that it is piece of ownership in a company and represent a portion of the company’s future earnings and dividends and a share of the their assets but the most important part is the earnings because if a company doesn’t have them then the assets will decline.

Individual company’s share price: Share Price = Company Earnings per share x Price-to-earnings-ratio

The Price-to-Earnings ratio (P/E for short) is further determined by: Earnings growth in recent history x Future Expectations of Growth Companies that have recently been enjoying growing profits, and are flashy and exciting and thus expected to see continued profit growth, are rewarded with higher P/E ratios and thus higher stock prices. The Future expectations of growth are higher for those stocks.

 

A good example of a currently stylish company is Amazon, which currently trades at a P/E of over 1000 (Amazon’s shares are worth $400 each, because their trailing twelve month earnings are .40 per share and multiplied by 1000 that is the $400) Amazon is a very special case and they’ve been trading present earnings for future growth but it illustrates a company that is highly in favor and given the benefit of a doubt for future growth. We don’t like to pay for future growth. We let other people do that. A less flashy very profitable counterexample would be the company International Business Machines or IBM. Its share price is only about $180 – yet it’s earnings per share are $14.40 and the P/E ratio is a nice conservative 12.5. If IBM P/E ratio were the same as the average S&P, IBM stock would be worth over $235! Currently the market is less euphoric about IBM’s future and believes there are many risks to it and gives it a discount to the average S&P P/E ratio. Whether this is wrong or right we won’t get into.

 

Basically the stock market expects Amazon to continue growing and expects challenges to IBM’s business. It could be right it could be wrong, that’s a whole different story. We aren’t going to focus on the fates of individual companies since we like to make things easy. We’ll focus on the market as a whole. So the key to us is that we aren’t paying an above average pricing on stocks based upon their earnings. I caution you with taking this too far and enter this example as proof. PE ratios are deceptive. In 2004, both Apple (AAPL) and Google (GOOG) were “expensive” stocks. Then they went up 1200% and 600%. The fact that Apple’s share price appreciated from $15 to $347 and Google’s $85 to $538, hammers home the point that analyzing trailing P/E ratios alone is not the bees knees. It does provide a great starting point for general market valuation and that is all we are looking to do.

Nobody can really predict future earnings of a company more than a few months in advance and even so there is a large amount of noise or random BS and you’ll notice that the numbers are subject to revision each day and the stocks are subject to wild swings based upon the opinions of these analysts. This is what causes stocks to fluctuate as estimates of the future vary wildly day to day and the stock represents new fears real or unreal. The same goes with the economy in general. People tend to fear recessions that don’t materialize and when they get over confident that there won’t be a recession see one. While we’re vastly simplifying things. The less we pay for future earnings the easier it will be to exceed those expectations. The more we pay for future earnings the higher the price we pay if those expectations aren’t met.

Since 1946 the S&P is up 7.4% a year and corporates profits are up 7.2% a year. It’s that simple, stocks follow profits. 

Price to Earnings is a great general yard stick to tell us how to divide our purchases of Stocks and Bonds. All things being considered equal I will always prefer Stocks and their power to grow earnings at fair multiples. When you buy a stock market index like the S&P 500, you’re looking at a whole collection of 500 large companies, over a period of many decades, you can see a much more sensible pattern. An average P/E ratio makes itself visible, which turns out to be around 16.4 exactly. They get this number by calculating a weighted average of the P/E ratios of ALL the 500 companies in the S&P500 index. So, you could say that when the stock market P/E ratio is above 17, it’s tending towards expensive. When it is below this number, it is ON SALE! You can of course dig deeper into the details and find exceptions to this rule, but a detailed statistical analysis of the market history shows that if you can buy the stocks when they are on sale way below 17, your next 10-20 years of investment returns are unusually good. If you buy when it is way higher than 17 you are likely to get lower-than-average returns. When stocks are trading at 17 P/E or lower, I tend to buy the Vanguard Total Stock Market Index Fund only. When stocks are above the 16 P/E ratio, I compare my expected return in stocks to bonds. The higher the P/E ratio the more likely I am to purchase the Vanguard Total Bond Fund and less of the Vanguard Total Stock Market Index Fund with future purchases.

The second comparison that takes place if the ratio is above 16 P/E is the current bond yield to the current dividend yield. If the average rate of growth of 3.5% then I add this to the dividend yield of the Stock Market and compare it to the average yield of the Total Bond Fund. If it is substantially in favor of either side at this point I will lean in that direction. The reason is I need to be substantially compensated for the risk of inflation with a higher bond yield in addition to the P/E factor. I the long run, company earnings and dividends tend to grow at a fixed rate – the same rate as the entire US economy, which has been about 3.3% after inflation for most of modern history. If you buy a stock which pays a 2% dividend, and its earnings grow at 3.5% per year, and the P/E ratio stays the same over time, it turns out you will get a 5.5% return after inflation (8.5% or so before inflation) on that stock. But if the stock market temporarily goes in or out of fashion and the P/E ratio rises or falls, your return can much be higher or lower. From the 1950s to the year 2000, the P/E ratio went up quite a bit, which provided great returns for investors over that period.

S&P 500 Track Record

In the Dot-Com peak of March 2000, the S&P index was teetering at a dramatically high P/E ratio of over 30. In this case, it would do best to purchase ALL Bonds and pare down the Total Stock Market Index Fund. Timing the market is fool’s errand but if the average P/E is this high you will do better in Bonds then in stocks. While In March 2010 ten years later, the companies were actually earning MORE money, but the stock index was worth about 30% less. That is because people were less euphoric over stocks at the time, so the P/E ratio was much more realistic in 2010. At times like this you will do substantially better with stocks then bonds and should not even bother with bonds. In March 2009, there was a massive stock market crash and the stock prices fell so low that the P/E ratio was only in the 13 range. A level that hadn’t been seen since about 1986. If you bought stocks back then,you are already up quite a bit as you have benefitted from going from the bottom of a recession to a more normal economy in addition to a change in investor sentiment. When things become a no brainer bargain you can pare down any positions you have in the Total Bond Fund and reallocate them into the Total Stock Market Index. Usually things lie in the middle and you should not try to time the market.

If the P/E of the stock market is fair then I compare the dividend yield to the bond yield. The bond yield must be a couple of points higher to compensate for the fact that stocks tend to appreciate in protection of inflation while bonds worst enemy is inflation. If it isn’t I still pretty much buy stocks. Currently the Total Stock Market Fund yields 1.7% while the Total Bond Fund yields just over 2%. The risk of inflation makes the Total Stock Market Fund a much better choice at a similarly yield especially since there is the expectation of earnings growth. Stocks are likely to outperform bonds. Usually this will be a harder a decision but right now nominal interest rates are very low which are not good for current bonds and so one would expect to be compensated more for the risk of inflation.

So what is the current P/E ratio of the index? It is the current price (1847) divided by trailing 12 months total earnings per share for the companies ($91.30). Giving a ratio of 20.23 – which is higher then the 16. So the stock market is right where it should be, historically speaking, and if this ratio persists, you will get a return equal to US GDP growth plus the current dividend yield that the stocks are paying right now: 1.83%. That adds to 6.83% before inflation. If, on the other hand, P/E ratios go higher due to enthusiastic investors pouring back in as they did in the 1980s and 1990s, you may get lucky – if you are doubly lucky enough to know when to cash out some of your gains into more stable investments before everything reverts back to the mean in an extreme scenario then do so. I still don’t recommend trying to outsmart and out time the stock market by timing a repeated series of buys and sells. If things are extreme like a P/E of 30 then it’s obvious or a P/E of 13 like in 2009 then I would act accordingly and either go nearly all into Bonds or Stocks. But if things lie in the middle I would just base my future purchases on the expectation of returns and not worry too much. Timing the market is a losers game. The only one that wins you when constantly trade is Wall Street from the fees.

The evaluation method determines if I’m crazy to add more to the stock portfolio at any given point in time. When the market strays quite far from the mean P/E ratio, that’s something to get excited about.If it’s low you aim to increase your purchases. If it’s too high you should aim to decrease your purchases or stop them. When the P/E is above the magical number I would tend towards purchasing more Bonds, using the Vanguard Total Bond Index Fund.

In review we recommend you get an account with Vanguard. We recommend you buy the Total Stock Market Index fund if the P/E of stocks is 17 or below. If it is 17 or above we recommend you compare the yield of the Total Stock Market Index Fund to the Total Bond Fund and insure that the Total Bond Fund is paying at least a few points higher and as things trend towards 25 and above, purchase the Total Bond Fund instead of the Total Stock Market fund increasingly and slow purchases Conversely as thing trend down to 17 and lower do not purchase the Total Bond Fund, but purchase The Total Stock Market fund.