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

 

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19 Responses to “How to tell when the Stock Market is on Sale”

  1. Steve June 9, 2011 at 11:08 am #

    I usually try to keep 40% in stable investments. However, whenever it feels like things are bad. When you take that 40% that hasn’t lost half it’s value and transfer it over to your broad market fund, that moment when you are about to click the confirmation button, and the fear is almost overwhelming….

    …that’s when I know the stock market is on sale.

    It is hard to do and it gets harder and harder to pull that trigger the older I get and the more money I have at stake. It’s really gotten almost to the point where I’m going to have to stop doing that because the emotions are beginning to overwhelm the logic.

  2. No Debt MBA June 9, 2011 at 11:12 am #

    As Warren Buffett says “Be fearful when others are greedy and greedy when others are fearful”. Like you say, low prices just mean stocks are on sale.

  3. RetirementInvestingToday June 9, 2011 at 11:21 am #

    Hi MMM

    I nice simple explanation. Thanks.

    I personally don’t follow the PE ratio at all but I do follow the PE10 ratio religiously. On my blog I post regularly a modified S&P500 PE10, a FTSE100 PE10 and an ASX200 PE10.

    You mention the long run average S&P500 PE is 16.4 which of course is the same as the long run average PE10. The difference is that you say the S&P500 is about fairly valued. I’m leaning more towards the thought that the market is overvalued. My modified S&P500 PE10 at last check is 22.7 implying quite a large overvaluation. Up until about 1995 PE10′s this high were very rare.

    I am therefore underweight the asset classes that I correlate with this index.

    Cheers
    RIT

    • MMM June 9, 2011 at 11:35 am #

      Hi Retirement Investing Today,

      Yes, very good point about the P/E10 meaurement. I also follow that one and you probably noticed that the “Further Reading” links at the bottom of the article use P/E10. I just didn’t want to make my own article any more complicated than it already was, since it was sort an introductory one.

      The only issue I have with the current P/E10 is that it includes all of the effects of both the Dot-com crash and the biggest financial crisis in history – in fact, nationwide corporate earnings were almost ZERO for about a year in the recent 10-year averaging period. If you look at the graph (http://www.multpl.com/s-p-500-earnings/) It could be argued that the current year’s earnings – still hurting from recession hangover, but mixing both good and bad economic factors – might be more representative of what companies are truly earning right now(?)

      Either way, I’m not a massive stock market optimist at the current level.. I have a somewhat neutral feeling about it and I am of course still leaving all my “old-man” retirement savings fully invested. But if there were to be another large drop sometime this year, investing could get quite exciting again.

      • RetirementInvestingToday June 9, 2011 at 12:09 pm #

        Hi MMM

        Yes I did see the PE10 link which I think takes data directly from Professor Shillers dataset. I use a slightly modified version which also includes earnings estimates to allow earnings to be estimated up to the datapoint I publish. Doesn’t make a lot of difference but hey it’s a hobby as well as an investment strategy :-)

        Yes agreed it includes the dot-com crash and the GFC. It also includes the 1907 Bankers Panic, the Great Depression and the 1973 Oil Crisis. These are the bust parts of the boom and bust cycle and are exactly why I use the PE10. I run a monthly series entitled a “History of Severe Real S&P500 Stock Bear Markets”. I’d appreciate your thoughts but from my side if this comes to fruitition I think we could be in for one more big leg down before normality resumes.

        Prior to the GFC the PE10 reached 27.5 and prior to the dot-com crash it reached 43.8. These valuations would have forced me to be underweight equities just as I am today.

        Of course DYOR.

        Great blog BTW.

        Cheers
        RIT

  4. Kevin M June 9, 2011 at 1:55 pm #

    This article reeks of market timing, how dare you! The buy and hold personal finance blog police are coming! Hide!

    But seriously, we check prices on everything else we buy, why not try to make sense of where the overall market stands when we buy a piece of it?

  5. MMM June 9, 2011 at 2:22 pm #

    So true, so true. There is a constant battle (even in my own head) between our natural tendency to think we are smarter than the market, vs. the endless number of studies which prove that even the most educated among stock analysts do no better than a blindfolded person throwing a dart when it comes to picking winning stocks.

    But the same studies say that there is some market advantage that can be gained by rushing in if you see an abnormally low P/E ratio and not rushing in if you see a crazily high one. It’s also the only advice Warren ever gives on stock investing – at the trough of the market crash in 2008 and 2009, he went on record saying stocks are an unusually good deal and they represented a great investment at that price. As usual, he was right.

  6. BeyondtheWrap June 10, 2011 at 1:16 pm #

    From the formula you gave, does that mean that the price to earnings ratio is simply the reciprocal of the dividend yield?

    If that is the case, then a stock is on sale when it’s dividend yield is higher than 6.1%. Is that right?

    • MMM June 10, 2011 at 1:40 pm #

      Not quite – because most companies do some mixture of keeping/reinvesting their earnings, vs. paying them out to shareholders in the form of dividends. So some stocks can be on sale even if they have no dividends. So (I think) the word “Earnings” actually means dividends plus the portion the company keeps (retained earnings).

      • Dave June 13, 2011 at 6:00 am #

        I vote that the BRE factor for P/E ratios be added to the permanent lexicon of stock market terminology. Thanks for this, MMM!

  7. brian June 13, 2011 at 11:22 am #

    Hmm…p/e versus p/b versus dividend yield. I’ve made a hell of a lot more money on p/b when buying indexes. I have made some fundamental mistakes in paying attention to p/e over p/b (or dividend yield). I reccomend you check out- What Works on Wall Street or anything written by William Bernstein.

    • MMM June 13, 2011 at 12:10 pm #

      Thanks for the book tip, Brian – I just checked my library’s online catalog and I see they do have What Works on Wall Street by James P. O’Shaughnessy.. so I have put it on my reading list and will read it when it reaches the top of the queue later this summer.

  8. Heath April 23, 2012 at 7:53 am #

    I’ve been voraciously reading your blog over the past few weeks (probably too fast, as I know I’ll never remember all of these details…). Anyway, it’s AWESOME stuff, and I’m slowly on track to becoming debt free :-) Who would have thought I could find an entertaining blog on personal finance?!

    My current question is: where the heck to do I find the P/E of the S&P 500? I’ve done some preliminary hunting around the interwebs, and can’t seem to find a regularly updated site which just comes right out and shows the P/E…

    Also: I vote for more cursing! :-)

  9. Robert June 20, 2013 at 4:45 pm #

    MMM,

    Enjoying the site, and appreciate you taking the time to share with all of us. Just curious about one thing though (and hopefully I didn’t miss this if you addressed this question already). Where do you park your cash when the Stock Market isn’t on sale?
    Many thanks.

  10. Rhodesie August 7, 2013 at 8:36 am #

    MMM,

    Thank you very much for all of the information you are posting. My question is similar to the one above from Robert on June 20. I would like to open up an account with Vanguard to invest in some of their index funds, but the market is not currently on sale. Should I hold off until the P/E ratio drops before opening my account?

    • Phil September 19, 2013 at 7:35 am #

      Most long term investors do not advocate trying to time the market because it’s too difficult to do regularly. There is a lot of value in dollar cost averaging, which is investing a constant amount at regular intervals regardless of market conditions. Step back from the stock chart; when the noise fades the trend is up. That being said, even John Bogle in “Enough” admits to shifting to 60% bonds when he thought the market was over-valued in 1999. Another theory is value averaging, where you are adjusting your allocation or investment amount depending on market conditions, but you still invest regularly. At the end of August, the Vanguard S&P 500 fund had a P/E of 17.4, P/B of 2.4, and yield of 2.0%. The P/E and yield seem to indicate a slightly over-valued market, but not like the P/Es of 30-40 in 1999. P/B is about average for the past 30 yrs and is more stable since it isn’t affected by write-downs or accounting manipulation. Also interesting is that book values of technology companies are low since they have more value in intellectual property, so it seems that this indicator should be increasing. The emerging market indicators are better now and could be attractive, but these are typically much more volatile. Read “The Intelligent Asset Allocator” for an excellent discussion of market valuation. Any thoughts on current market conditions MMM?

  11. LEO September 26, 2013 at 9:04 am #

    Current P/E for the S&P 500 can be found here (along with a link to the PE10):

    http://www.multpl.com/

    Currently stands at 19.37 — which is high historically, but given the extreme boom-bust cycles of the last three decades (financial de-regulation, anyone?) is not extraordinary.

  12. VV February 5, 2014 at 4:34 pm #

    MMM,
    first of all I’d like to thank you for the informative and entertaining posts I’ve been reading for the past few weeks.

    What is your opinion of the Schiller PE ratio as a market valuation indicator? Currently it’s 24.32 whereas the mean is 16.51 indicating that the market is exceptionally overpriced. On the other hand, the S&P 500 PE ratio is 18.56 with a mean of 15.51. The difference in the two is significantly different.

    I have some amount of cash that I have been waiting to invest in the market, but based on this analysis would you agree that the market is overpriced and that my money should instead go to a more stable investment like a REIT? You recommended the SNH REIT back in 2011 which currently yields 7.18% (pretty good). Has this been a good investment for you and would you still recommend it?

    Thanks,
    V V

  13. Alec Williamson February 13, 2014 at 9:29 am #

    I have my entire 457b nest egg in cash right now and due to fear and thinking I knew better, made a paltry 6% in 2013. I was convinced a major correction was coming, and of course that never materialized. Big and expensive lesson. I am stuck in a state of paralysis now, because I am sure the minute I put it back in the market, we will get the correction I so wrongly predicted last year. Any suggestions?
    Oh, and I lost a huge amount of a windfall I received a few years ago betting on some sure thing small cap stocks. Never again! You cannot beat the market and cannot get rich quick in the market, it is a fools errand! Low cost index funds are indeed the smart way, and a much less stressful way to invest also. Thanks MMM, Great advice as always!

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