Should You Sell Low and Buy Lower?
Posted by Larry Brundage on June 07, 2012
The one certainty in the investment markets is that there are no certainties. That conundrum often makes investing a very frustrating activity, particularly at a time during which you analyze a market, decide it is very obviously cheap and yet it continues to get cheaper. We believe we are in one of those periods now since our analysis shows the stock market is cheap relative to its historic pricing and in comparison to the bond market.
How does one decide that the stock market is cheap? There are many metrics that can be and are used, but two of the most prominent are the ratio of stock prices to what they earn, the P/E ratio, and the yield level of the dividend payout or simply the dividend divided by the stock price. Those metrics can be examined on an individual stock basis or they can be calculated for an entire index of stocks such as the S&P 500. The following chart shows a history of P/E ratios since the beginning of 1962. The numbers across the bottom of the chart are P/E ratios. The first bar on the left, which is zero indicates that there are no days since 1962 that the P/E ratio of the S&P 500 was 6 or less. The second bar indicates that there were 15 days during which the P/E ratio was 7 or less, but greater than 6. Subsequent bars follow in a similar manner. So for example you can see that there were more times that the P/E of the market was less than or equal to 18 but greater than 17 than any of the others.
Currently the P/E ratio of the S&P 500 is 13. If you were to add up all of the days represented by these bars and calculate how many were at 13 or less, you would find that less than 24% of the time the market had a P/E of 13 or less. Thus relative to the history of the market, we are at the cheaper end.
There is another aspect to this that needs to be examined too. The market’s P/E ratio is sensitive to interest rates. Generally the higher the interest rates, the lower the market P/E ratio. This makes sense intuitively because a rational investor weighs the expected return of an asset relative to the risk they are taking by buying that asset. For bonds (which are generally thought of as a low risk asset class relative to stocks), the higher the interest rate, the higher the expected return relative to the risk. Thus in a high interest rate environment even if the expected return is not as high as it is for stocks, the attractiveness of the return relative to the risk pushes some investors to move some of their assets out of stocks and into bonds. If you were to calculate the average yield on the 10 year U.S. Treasury bond for all of the days for each of the bars shown in the graph, you would find that the average for all of the bars at a P/E ratio of 13 or less was never less than 7.74%. The current yield on the 10 year U.S. Treasury is about 1.6%! Thus we are not even close to the level of yield that existed during such low P/E ratio environments and that would push investors out of stocks into bonds.
The dividend yield on the S&P 500 is 2.16%, comfortably higher than the yield of the 10 year U.S. Treasury bond. For those of us that invest the portfolios at HFM, it has only been over the last few years that we have ever seen stock yields above bond yields in our investment lifetimes. We should point out that by comparing stock yields to bond yields, we are not suggesting that it is appropriate for all investors to use stocks as a source of income rather than bonds. However, it does point to the relative cheapness of the stock market.
At this point in the discussion you could reasonably be thinking, ok so the stock market is cheap, but if it could get cheaper, why do I care. The answer to that question really has 3 parts. The first is, based on our discussion of interest rates above, we believe that the probability that the market will get a lot cheaper is reasonably low. The second point is that there is never a clear signal when the market hits a low point and begins to rally. We would all like to think that we would recognize that point, but historically very few people do, even in the professional investment community. So when the market is cheap we believe it is reasonable to begin to add to your exposure to stocks, even to the point of raising that exposure above your current target for stock exposure. The final point can best be illustrated by the following graph:
In the graph on the left each dot represents the S&P 500 at the beginning of a quarter going back to 1954. The x-axis is the P/E ratio of the market at the beginning of the quarter and the vertical line is where the current P/E of 13 is located. The y-axis represents the actual market return over the subsequent 12 months. You can see from this graph that generally, when the P/E ratio was high the subsequent annual return was low and when the P/E was low the subsequent annual return was higher. However, as you look at this graph the pattern is not prominent, which leads you to realize that even in very cheap or very expensive markets you can not expect the market to perform as you might expect over the ensuing year. That brings us back to the frustration we pointed out at the beginning of this discussion that a cheap market can get cheaper. But there is hope. That is expressed in the chart on the right which has the same P/E information yet it shows the subsequent market return over the next 10 years. This is a much more pleasing graph. The data is behaving in a much more orderly fashion, indicating that over a longer period of time the market really does tend to perform well after periods of relative cheapness. Unfortunately, you just have to be patient!
Note: The data source for this article, including the graphs was Bloomberg, L.P. The inspiration for the second two graphs was from J.P. Morgan’s quarterly chart package.