By Byron L. Studdard, CFP®
Learn more about Byron on NerdWallet’s Ask an Advisor
At a recent investing seminar I conducted, a gentleman voiced a concern that is common in the current high-flying stock market: He didn’t want to invest in stocks until after a major correction — after the market falls substantially.
His skittishness is understandable. It’s never a matter of whether a bull market will correct, but of when. Millions of investors got hurt badly by paying up for stocks in 2007 and 2008, only to lose value in the market meltdown of 2008–2009. Now, many of these same individuals are sitting on the sidelines, looking for a good time to get back in. To them, the current market ascendance is a warning sign to wait for a correction so they can get back in at low prices and ride the next uptrend.
One problem with this thinking is that, just because the market crashes, this doesn’t mean that stocks will necessarily be a good buy soon afterward. It’s not just whether their prices go down; the point is to assess their potential to go up based on what’s happening now.
Trying to predict the top of a rising market is a fool’s game. For example, take the bull market that started in the mid-1990s and ran until it corrected in 2000. Anyone sitting on their cash during this period missed out on substantial gains. And those who perennially shorted the market from 1994 to 2000, betting that it would soon correct, took a bath every year for several years.
Yale economist Robert Shiller published a book in the 1990s titled “Irrational Exuberance” (borrowing the phrase from then Fed Chairman Alex Greenspan), expressing concern that the go-go stock market at the time might soon be headed for a fall. Since then, the phrase has become a classic moniker for bubble-prone markets. Well, there’s an old Wall Street saying about the perils of anticipating corrections that are nowhere near: “The market can remain irrational longer than you can remain solvent.”
Investors seeking to glom on to growth might consider what price/earnings ratios (a stock’s current price divided by its earnings – a fundamental measure of value) suggest about the relative longevity of the current market. Historically low average P/E ratio might indicate room for growth.
Since 1900, the US equity P/E ratio has averaged around 15, which is about where it stood at the end of 1994. Over the next six years, as the roaring bull market fueled day-trading and speculation, the average P/E ratio doubled. It climbed as high as 46.50 by 2001 before the market crashed.
Investors, motivated by visions of sudden wealth, poured money into dot-com stocks that had no earnings whatsoever. Thus grew the tech bubble.
When the internet music stopped, people like the gentlemen at my seminar didn’t have a chair to sit in, and they lost big time. Those memories might prevent them from investing in this or any market. However, the P/E ratio for the Dow the middle of this month is about 16 — not terribly fearsome, considering that companies now are leaner and can borrow money cheaply. This cheap money seems to help propel profits and boost earnings, thus driving the overall market. That doesn’t mean that the market will ascend without some corrections along the way, but comparing this market to the 90’s doesn’t make sense because of substantially different factors.
It’s important to keep this type of analysis in perspective. P/E ratios are just one of many factors you should consider. Shiller’s observation that there were problems with the way that market average P/E ratios were being calculated prompted him to come up with the Shiller P/E, which uses the past decade’s average inflation-adjusted earnings of stocks in the S&P 500.
No matter which version of the P/E ratio you use, charting the ratio on a monthly basis will give you one more tool to help determine your investment strategy. It’s not a matter of when to get into the stock market, but of how — and how much. If you invest based on the right principles and use the right techniques, you have a better chance to protect against dire losses and capture good net returns in most types of markets.
Here are some points to keep in mind:
- As the old saying goes, don’t fight the tape (the market). Instead, try to capture returns based on what it’s doing. This means playing the market up and down. If money is flowing into the market, this is a good sign that no correction is likely imminent. If money is flowing out of the market, a correction might be coming and it might be wise to convert some of your stock holdings to cash and offset risks on remaining stocks through shorting (making investments that essentially bet on their decline).
- Regarding precisely when to sell, develop a sell discipline that includes stop-loss limits – many successful investors sell their positions if they drop 8-10% from the purchase price. Whatever the percentage you choose, you must have the discipline to stick to that number.
- The market’s direction always matters, but so does the advent of companies that represent a great investable proposition because they’re doing something significantly different — either doing business in a dramatically different, highly effective way or coming up with products or services that are unique and highly attractive.