Stock Market Talking Points {Part Four}

Today is part four of our Stock Market Talking points series. These posts are based on a Wall Street Journal article published a few weeks ago which we are featuring in serialized form. In the series the author, Brett Arends, takes what I will term 10 very common market talking points from both brokers and financial advisors and posts a rebuttal to each. My comments are in response to each section of the article.

6 "The market's really cheap right now. The P/E is only about 13."

The widely quoted price/earnings (PE) ratio, which compares share prices to annual after-tax earnings, can be misleading. That's because earnings are so volatile -- they're elevated in a boom, and depressed in a bust.

Ask your broker about other valuation metrics, like the dividend yield, which looks at the dividends you get for each dollar of investment; or the cyclically adjusted PE ratio, which compares share prices to earnings over the past 10 years; or "Tobin's q," which compares share prices to the actual replacement cost of company assets. No metric is perfect, but these three have good track records. Right now all three say the stock market's pretty expensive, not cheap.

In my opinion the best way to determine the relative attractiveness of stocks is to apply the inverse of the PE ratio which is the earnings yield and compare that to the rate of return on the 10 year treasury which is as of this writing trading just under 3%. So for example if you think as I do that S&P 500 earnings will come in a midpoint of about $80 per share this year that gives the market, currently trading around 1122 an earnings yield of just over 7%. {$80 of earnings / 1122 S&P 500 market price as of this writing}

At 400 basis points to the 10 year, that is still an attractive level of valuation by the way I set parameters for clients. If we use a midpoint range next year $85 for the S&P {which would indicate corporate earnings growth slightly higher than 6%} then we come up with a current earnings yield of around 7.5%.

Now it's possible that earnings, that's the E in the equation, will be higher or lower as we proceed through the year. That's where fundamental analysis needs to kick in. Earnings yield has a pretty good track record as well forecasting future growth.


7 "You can't time the market."

This hoary old chestnut keeps the clients fully invested. Certainly it's a fool's errand to try to catch the market's twists and turns. But that doesn't mean you have to suspend judgment about overall valuations.

If you invest in shares when they're cheap compared to cash flows and assets -- typically this happens when everyone else is gloomy -- you will usually do very well.

If you invest when shares are very expensive -- such as when everyone else is absurdly bullish -- you will probably do badly.

I agree with the author's statements here. While valuation means different things in different environments This is why it must be the fourth leg of the investment chair along with overall market metrics, fundamental analysis and money flow analysis.




Link :Stock Market Myths.

We'll conclude this series next week.

*Long ETFs related to the S&P 500 in client and personal accounts.