Wednesday, December 03, 2008

Is It Time to Buy?

With the collapse in stock prices the question turns to "is it the time to buy or should I wait."
In the past I said the DJIA at around 8,000 is accurately valued. Understand this is ACCURATELY valued, meaning not a deal, nor over priced. It's about where it should be. And the way I base this is on the S&P 500 P/E ratio.

Historically the S&P 500 P/E ratio trades around 15 - ie- you pay $15 in stock price for $1 in earnings. The hope is, with the recent drop in stock prices, stocks are now below this average, perhaps even as low as a P/E of 7 which it was back in the early 80's and for most of the 70's. The problem is, even with the drop in stock prices, it is not;



Currently the stock market is trading around a P/E of 14. A bit lower than the historical average, but not a "steal" by any means.

Furthermore, this says nothing about future earnings which are bound to be lower as the economy continues its trudging through a recession. If earnings drop, which I'm betting they will, this will only provide less E for the P that you're paying, and thusly P will have to drop.

Sorry to be the bearer of bad news, but good or bad, truth is truth.

However, there is some solace, because Obama will fix everything.

9 comments:

dtrum said...

I doubt that going by P/E ratios is a good investment strategy. As you can see in your chart, there have been periods where the ratio was well over or under 15 for a decade. It seems that waiting for the ratio to fall under 15 in order to buy in is a strategy that only pays off in the very long run.

As the famous economist John Maynard Keynes once said "the markets can stay longer irrational than you can stay solvent". This is true as well for irrational exuberance as for irrational scare.

Michael said...

On the topic of stock valuation ratios, Here's Arnold Kling talking about Tobin's q today.

Anonymous said...

Motivations have changed.

So we can't suppose that investors, especially in grievous times like these will accept higher risk and higher PEs as well.

As leverage comes out of the financial system, stocks will experience headwinds.

This does not also account for the lowering of incomes due to what will be the worst recession in 2 years. There will be less interest AND less cash available to press stocks upward.

The dividend WILL reassert itself as THE most important fundamental, if only because it was the most neglected.

Ryan Fuller said...

"As the famous economist John Maynard Keynes once said..."

I really wish people would just get over Keynes already. The guy was wrong. The Keynesians have been doing nothing but make excuses for their failures since stagflation curbstomped their beloved Phillips Curve more nearly four decades ago.

Or you have neo-Keynesians like Krugman arguing that liquidity traps produce a vertical aggregate demand curve, so there's no harm in cartelizing all labor. Gee, I wonder what would happen to the unemployment rate in a recession if the cost of labor were to suddenly jump towards infinity?

It's pure economic wankery. I've seen Keynes references flying like confetti lately, as though he had some profound wisdom for hard economic times. The fact is that Keynes got blindsided by the Great Depression and lost a ton of money in the stock market crash, while Ludwig von Mises put his money where his mouth was and declined a prestigious position at Austria's central bank, citing the impending crash as his reason and not wanting to have his name associated with it.

Maybe we ought to spend more time listening to the people who accurately predict economic events and less time worshiping the whores who come after the fact to try to explain how the whole thing can be fixed with just a little bit more government power and intervention.

dtrum said...

I hate to defend Keynes, as I certainly don't want to be called a "Keynesian". However, as wrong as he was with most of his conclusions and policy advices, he was certainly not a complete idiot. The assumption of price and wage stickiness in the short-run is certainly one of the more important advancements of 20th century economics.

Besides, what's your point anyway? You didn't bring forward an argument against Keynes' quote. How do you call it when people invest heavily into stocks when the P/E is already at over 20, like in 1995? Or when they think that house price are gonna increase forever. I'd call it irrational.

Ryan Fuller said...

"Besides, what's your point anyway?"

That Keynes is overrated. That's not to say that everything he said was wrong.

"You didn't bring forward an argument against Keynes' quote."

That's right. I didn't say it was wrong either. Rather, I was ranting about Keynes in general, since he was mentioned.

Michael said...

I'm just about to start reading Keynes, but taking it all with a grain of salt. I figure its good to know what everyone is making a big fuss about. Keynes is like Napoleon Dynamite, people either think he's the most amazing ever or think he's overrated.

Im sort of learning economic theory on my own, and I want to dip into it all from classical, monetarists, keynesians, chicagoans, austrians, you name it. I like the idea of heterodoxy, but I get the feeling it will leave me indecisive about everything.

And Napoleon Dynamite is overrated.

Ryan Fuller said...

"Im sort of learning economic theory on my own, and I want to dip into it all from classical, monetarists, keynesians, chicagoans, austrians, you name it. I like the idea of heterodoxy, but I get the feeling it will leave me indecisive about everything."

That's how I got started. I actually got into economics through the Austrian school, and eventually branched off a bit from there when I found myself disagreeing with enough of their positions to put myself somewhere between them and the neoclassicals. I think I came out of it ok. In particular I found Bryan Caplan's "Why I'm not an Austrian Economist" essay to be excellent.

Robert Miller said...

Keynes' theory of sticky prices set the stage for some later research which is not without merit. Clearly prices do not adjust instantaneously and no one can doubt the presence of bubbles. But I think efficient markets are a better model upon which to base most economic policies. Especially in microeconomies, people really do respond to the incentives they're given - hence, the housing crisis.

But Ryan is right when he says Keynes is overused. The Philips Curve exploded and Keynesians are scrambling to put the pieces back together.

In Keynes' original models, government could maximize aggregate output by taxing 100% of income and spending it. Now what bloody fool would believe:

1. People would keep working at a 100% marginal tax rate.

2. Government would efficiently and effectively allocate resources to maximize welfare or even maximize output

Keynes gave big government politicians and marxists everything they ever wanted for Christmas: a reason to increase taxes.

Keynes drank a bottle of champagne every day of his adult life. On his death bed, he said that his only regret was that he did not drink more champagne. Now that's some advice from Keynes with which I agree!