Buy Low...Sell High

The above phrase represents one of the great truths about investing that has survived every type of market; both bulls and bears. Today, I want to look at this investing truth from a slightly different angle. Yes, we will still buy low and sell high, but we are going to talk about something other than price.

Price is relative. How do we determine “high” or “low?” High for me might be $10.00. For you it might be $100.00. A high or low price is a very personal observation and is a very accurate observation for any given individual. Our personal observations are what create the market. If we all thought that stock “A” was high, there would be no buyers. The markets would come to a grinding halt. So if determining whether a particular price is high or low is difficult, if not down right impossible, what attribute can we measure to help us make our investing decisions?

The lowly Price/Earning Ratio seems to fit the bill. I just finished reading two different articles written by two people in different countries that come to the same conclusion regarding P/E ratios. Both authors, by doing extensive research, have determined that the opportunity to make a decent return on your investment increases dramatically when the P/E ratio is below historic averages.

When looking at individual stock issues there are, I believe, a few more criteria to research. For example, debt to equity ratio, price to book ratio, price to cash flow, and price to sales ratio. These additional items will help you to weed out the dogs.

I prefer to use the P/E ratio of the overall market as a gauge of how high the market is and as the authors above noted, most of their research involved looking at the market as a whole and then comparing market returns over a period of years. The research is astounding. If you invest in stocks when the market P/E ratio is 10 or below, you will probably enjoy double-digit returns on your investments over the next 10-20 years. However, if the market P/E is 19 or above, chances are your investments will go nowhere or even down over the next 10-20 years. Now, in 1982, which is considered to be the end of the last secular bear market, the average P/E ratio for the S&P 500 was less than 10. From 1982 through 2000, earnings increased by 120% and the market increased by six times. (On an inflation-adjusted basis.)

Where are we at today? Well, depending on whose market P/E numbers you use, the S&P 500 P/E ratio is north of 20 as we speak. That would indicate that we are in for several years of below average market returns. (This could explain why Warren Buffet is holding a lot of cash right now.)

I hope you are not counting on 10-20% returns over the next 10 years to pad your retirement nest egg because it looks like those types of returns are history for the foreseeable future. If you would like more information about market P/E ratios and secular bear markets, grab a copy of Unexpected Returns by Ed Easterling. It is a fascinating book that will open your eyes.