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How the Market Works

A Simple Rule for Investing in 2017: How the Market Works

Posted by kdadmin on December 31st, 2016.

A Simple Rule for Investing in 2017: How the Market Works

Do you prefer quality over quantity? I do.

Instead of listening to every media outlet hawk their predictions for the stock market in 2017, how about a simple chart that covers 136 years of history and offers a clear message?

Price-Earning Ratio Explained

Price-Earnings Ratio is simply the price of a stock divided by it’s earnings. In other words, if the price of a stock is $100, and the earnings per share is $4, then the Price-Earnings Ratio is $100 divided by $4 = 25.

Now, if this $100 stock suddenly dropped to $40, but was still paying $4 per share, then its Price-Earnings Ratio would be $40 divided by $4 = 10.

If you were an investor in a company, and could get $4 in earnings from a share of stock, wouldn’t you rather only pay $40 for those earnings than $100? A lower PE Ratio offers a better return on your investment.

Investors evaluate the relative price of a stock by its Price-Earnings (PE) Ratio over a long period of time to determine if the current price is high or low compared to its average. So, if the stock from our example normally had a PE Ratio of 19, then a PE Ratio of 10 would imply that it was unusually cheap (a buy signal for an investor); whereas a PE Ratio of 25 would imply that the stock was unusually expensive (a sell signal for an investor). This is how the market works.

PE Ratios are also often used to evaluate groups of stocks (in an index) so that investors can get a quick picture of how expensive or cheap the group of stocks might be relative to other dates in the market’s history. The chart above illustrates the PE Ratio of the S&P 500 since 1881, adjusted for inflation. For reference, the median PE Ratio of the S&P 500 is roughly 16.

How Does This Help You?

If you apply what you learned about PE Ratios above, you will likely notice something very quickly. First off, the current PE Ratio of 28 is quite high compared to its median of 16. Further, there have only been three other times in history have PE Ratios been this high.

  1. Right before the stock market crash of 1929.
  2. Right before the stock market crash of 2000.
  3. Right before the stock market crash of 2008 and the subsequent Great Recession.

If you look closely, you will notice that the S&P 500’s current PE Ratio of 28 very recently surpassed the highest PE Ratio right before the stock market crash of 2008.

A Simple Rule for Investing in 2017

Now look at the chart below. It’s the same chart, but with grey bars added to show every recession we’ve endured. Do you notice anything about the relationship between high PE Ratios in the S&P 500 and the timing of subsequent recessions?

Yup. Recessions nearly always follow high PE Ratios. When the PE Ratio gets too high, eventually investors aren’t willing to pay those prices for the stock, and the stock prices drop, often drastically, until investors start shopping for low PE Ratio bargains. Of course, past performance is no guarantee of future results …

The Simple Rule for Investing in 2017 is: “Pay attention to your PE Ratios.”

If a stock or an index’s PE Ratio is WAY above normal, it’s over priced. The end. Overpaying for anything usually results in a loss when you try to sell it. No matter how smart you think you are,the goal is always to buy low and sell high.

The “New Normal” is a Myth

As if on cue, the financial media is being flooded with articles about the S&P500’s “new normal” and nonsense about how “earnings don’t matter,” “the new PE Ratios are different now,” and “growth doesn’t always require increasing revenue.”

This sort of news should remind you of 1999. What happened next? The stock market crashed. The bottom line is that earnings DO matter. Why would you, as an investor, be willing to pay a higher price for a share of stock if its earnings hadn’t increased, or weren’t forecasted to increase? You wouldn’t.

If you pair the charts above with those in my article, “Hi, I’m Full Employment: How the Market Works,” you will have a very different picture of where we are at in the market cycle, and where tripe like the “New Normal”is likely to lead us.

For Clients Only

Of course, there are LOTS of investment opportunities other than the S&P 500. If you’re one of my clients, you can expect an email shortly that discusses several of these options and what I plan to do about them in the coming months.

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Happy New Year!

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