How to tell when the Stock Market is on Sale

In a recent article in this Investing series, I mentioned that the S&P500 index had delivered an annualized return rate of a little over 11% (7% after inflation) for the past sixty years.

But what caused that generous rate of return? And is there any way to know if the market is likely to return a similar, or drastically higher or lower rate during our own investing lifetimes?

To make a surprisingly educated guess,  you just need to understand the formula that determines each 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 these factors:
Earnings growth in recent history x Bullshit Random Estimates of Further Growth

Thus, 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.

A good example of a currently stylish company is Google, which trades at a P/E of 20 (Google’s shares are worth $500 each, because their earnings per share are $25, multiplied by the P/E of 20)

A less flashy but still very profitable counterexample would be the oil company Chevron. Its share price is only about $100 – earnings per share are $10.30 and the P/E ratio is a nice conservative 9.71. If the P/E ratio were the same as Google, Chevron stock would be worth over $200! This is because investors expect Google to grow much faster than Chevron over the coming years.

But since nobody can really predict future earnings of a company more than a few months in advance, the Bullshit Random Estimates factor is subject to revision each and every day, which is why the stock market fluctuates so wildly.

Luckily, when you’re looking at the 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 the number 16.4. 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 16.4, it’s unusually 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 16.4, your next 10-20 years of investment returns are unusually good. If you buy when it is way higher than 16.4, you are likely to get lower-than-average returns.

This is because in 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.

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 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.

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 of bargainville that hadn’t been seen since about 1986. If you bought stocks back then, you are already up about 100% in two years because both earnings and the ratio (investor enthusiasm) have grown.

So what is the current P/E ratio of the index? It is the current price (1280) divided by last year’s total earnings per share for the companies ($78.86). Giving a ratio of 16.23 – right around the average.

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.

I still don’t recommend trying to outsmart the stock market by timing a repeated series of buys and sells. But I still like following this evaluation method to determine 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.

Further reading:
big graphs on stock market P/E ratios, smoothed out over the past 10 years to give you what they call the P/E10 ratio: http://www.multpl.com/
a longer and more number-filled explanation of how to value the stock market: http://www.investorsfriend.com