When To Invest In U.S. Stocks: "Amazing Graph #1" Shows You the Right and Wrong Times
When To Invest in U.S. Stocks: "Amazing Graph #1" Shows You the Right and Wrong Times
By Dr. Mark Skousen, Chairman, Investment U
Thursday, February 23, 2006: Issue #513
I'll never forget a meeting I had with Princeton Professor Burton G. Malkiel in his offices a few months before the beginning of the 21st century. He is the premier advocate of the efficient market theory and the famed author of A Random Walk Down Wall Street.
When I came into his office, he showed me a long-term chart of the price-earnings ratio of the stock market. He and I stared at the chart and couldn't believe our eyes
The P/E ratio of the S&P 500 Index was higher than it had ever been, even higher than 1929. How long could the bull market of the 1990s last? Were we headed toward a 1929-style crash? We shook our heads in disbelief. We knew the writing was on the wall.
In this issue, we'll review how to determine when to invest in U.S. stocks, based on some very strong indicatorsincluding what led up to the 21st century's first stock market crash
The Chart that Predicted the 2000-03 U.S. Stock Market Crash
It was only a few months later when the stock market broke and began a long three-year slide that saw the tech-laden Nasdaq lose 70% of its value.
Yale Professor Robert J. Shiller is another colleague who has written a great book on the use of the P/E ratio as a key indicator of stock market performance that investors can in deciding when to invest. He recently published a second edition of Irrational Exuberance, a bestseller. The first edition came out in 2000, predicting a U.S. stock market crash based on the P/E ratio. He had good timing and was right on the money, unusual for an academic economist.
Here is the price/earnings ratio of the S&P Composite Index from 1881 until the present.
Source: "Irrational Exuberance" by Robert J. Shiller, Professor, Yale Department of Economics
What is the P/E Ratio? Why Does It Factor in Stronglyin Deciding When to Invest in Stocks?
First, a definition: The P/E ratio is the current price of a stock divided by the earnings per share from its most recent quarterly report.
Economists have proven that, over the long term, stock prices are determined primarily by the profitability of the company. Why has Dell (Nasdaq: DELL) risen 10,000% in the past 15 years, while General Motors has lost 70% of its value in the past six years? Dell has been extremely profitable; GM hasn't.
But price is also very important. Even if a company like Dell is highly profitable, investors may bid up the stock price too high. Nobody likes to pay too much, even when it's a good thing. Consequently, investors often look at the P/E ratio and compare it to similar companies to make sure they don't overpay.
Sometimes the whole market can be overbought, and that is clearly what happened in the U.S. in the late 1990s and early 2000s. (At that time, Dell was selling for nearly $60 a share, twice its current price.)
Wise investors took profits in the late 1990s and early 2000s, even on highly profitable companies like Dell.
What Are P/E Ratios Telling Us Now?
As you can see from the chart, the U.S. stock market, as measured by the S&P 500, is much more reasonably priced today than it was in 2000, with a current P/E ratio of around 18.
Still, the stock market in general is fully priced from a historical point of view. Wall Street is no bargain today.
My Recommendation on Investing in U.S. Stocks:
I would avoid U.S. stock market index funds at the present time. Better to search for bargains within the market, or individual sectors. Or check out some of the foreign markets, especially emerging markets, like the iShares MSCI Emerging Markets Fund (AMEX: EEM), which are selling at a lower P/E ratio.
Stay tuned for "Amazing Graph # 2."
Today's Investment U Cribsheet
- While U.S. stocks are "fully priced" at the moment, several overseas investment markets are quite attractive. For a closer look, see Investment U # 497, Stock Market Predictions for 2006: A Huge Bull Market in Foreign Stocks, and Investment U # 503, Investing in China: Guess Who Just Replaced America As the World's #1 Exporter of IT Goods?
- As I mentioned above, A Random Walk Down Wall Street, by Burton G. Malkiel, and Irrational Exuberance, by Robert Shiller, are two of the most popular investing books available and are certainly worth reading.