Pimp Your Finances

There is no way to predict – let alone time – the market.  The best that you can do is to balance current financial news with historical context.  Past activity is no indicator of future performance, but its often one of the most valuable tools we have in trying to figure out if the market is – historically speaking – a bargain.

I am not confident in my ability to pick individual stocks, so this discussion applies to index funds, whether they be broad such as the S&P 500 or international index funds, or more targeted like mid-cap or small-cap funds.

One indicator of the value of a stock is its price-to-earnings ratio.  The price is the market price of a stock, and the earnings is the earnings per share for the most recent twelve month period.  It stock A has a price of $50, and earnings of $10 per share, the P/E ratio is $5.  You are essentially paying $5 for every dollar of earnings.  In general, when comparing similar companies, a stock with a lower P/E ratio is seen as a more attractive investment, as you are paying less for every dollar of earnings.

Here are some of the current P/E ratios for a variety of countries and indices: (source: http://finance.yahoo.com/expert/article/futureinvest/118916):

The last time prices and P/E ratios were this low was in the late 70’s and 80’s, but the economy is in much better shape today.  The unemployment rate then was 10.8%, more than 4% higher than it is today.  Inflation was much worse too, hitting as high as 15%.

So why is the low P/E ratio significant?  Historically, the P/E ratio of the US stock market has been around 15.  This suggests that current stocks MAY be underpriced.  Again, past performance is not an indicator the future, but it is one thing to consider.

Additionally, starting in 1982 - the last time P/E ratios were this low – the US experienced one of the biggest bull markets in history.  In January 1982, the Dow Jones Industrial Average closed at $871.10.  Five years later (December 1986), it had more than doubled to $1895.95.  Another five years later (December 1991), the average closed at $3168.83 – almost four times as much as it started in 1982.

This growth isn’t typical, but it does seem to suggest that stocks could be in for a big rebound in the next few years, even if there is still another year or two of declines.