Summer Clearance Sale on US Stocks!

Stock market watchers like myself have had an entertaining couple of weeks recently. Amid lots of dramatic economic and political news, the S&P 500 index has dropped from a July level of 1356 down to 1199 (as of Friday August 5th). This 157-point drop works out to almost 12 percent of the value of  the index.

In other words, in just two weeks, the market value of the 500 largest companies has dropped by about $1,260,000,000,000.00 (1.26 TRILLION dollars). All this happened without any change to the earnings of the companies – it’s all due to the random speculations of market traders (“we don’t like the new budget deal! that debt crisis stuff in Europe is scary! hey, stocks are going down, let’s sell them because they are going down!”)

For those of us index investors who don’t care about short-term factors, and who know that in the long run, buying at a low price-to-earnings ratio is the only real way to increase your odds of higher long-term returns, this means stocks are 12% more attractive this week than they were on July 22nd. If you think of the stock market as a machine that hopefully delivers 9-10% annual returns to you before inflation, this is like getting an extra 1.2 YEARS of investment gains added to your return.

So is it a good time to invest?

In an earlier article called “How to tell when the Stock Market is on Sale“, I suggested that stocks in an S&P index fund start to become a good deal when the price-to-earnings ratio is below 16.4, the long-term average for US stocks if you start your counting at the year 1881. (Note that this is the conservative way to measure, since the average P/E ratio since 1950 is more like 18.6, and some market optimists start their own counting in the 1970s or even 1990s).

When I wrote that article, the S&P500 index was at 1280, and the total company earnings for the most recent year were $78.86, giving a ratio of 16.23 – right around the average.

Now the index is 1199, and the earnings have grown to $82.13. Because despite what you read in the complainy news headlines, the US economy is quite healthy overall and many companies are raking in record profits. The new P/E ratio is therefore 14.6!

More conservative investors like Robert Shiller, author of Irrational Exuberance will tell you that looking at just the current year’s P/E ratio is naive – you should look at a ten year rolling average of earnings to see how the stocks are really doing. In that case, even with the sale, we are still at a ratio of 20.7. This method would tell you stocks are still expensive – 26% overvalued. On the other hand, while they are  higher than the historical average since 1881, stocks are still cheaper than they have been for the last 18 years or so (except for a couple of months right around the Great Financial Crisis of 2008).

So, I’ll leave it up to you to make your own investment decisions. But for my part, I’m currently re-buying the shares I sold off earlier this year to kill off the mortgage, at a 12% discount. And I’ll continue to add to the stash over time if the panic and reduced share prices persist. To make money in stocks you must buy low, benefit from a reasonable dividend yield, and hopefully eventually sell high as well. This feat is made much easier if you can manage to buy during periods of great turmoil and scary news headlines – i.e., when stocks are on sale.

Update! I wrote that on the weekend in case people wanted to start thinking about picking up some stocks this week. Then on Monday the S&P Index dropped another 6.66%. So the total discount is more like 18% now. Apparently this is one of the top 20 drops of all time (you need to get to the 2008 level of over 40% to get into the top ten, since the 1900-1949 period was loaded with megacrashes).

I clicked ‘buy’ on Monday afternoon with all of the spare vacation earnings in my bank account. Perhaps I’ll go out and earn some money this week so I can buy more shares if the rout continues.