This Is How To Tell When The Market Is Bottomed

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How can you tell when a stock price has bottomed and when it has topped?

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Is it possible to have a successful economy when we also have deflation? I define “successful” as an economy that has a continuous and steady increase in production, productivit.

The degree of difficulty to answer this is certainly high. To be able to predict tops and bottoms is probably the most sought after piece of information on the share market. I can say many have tried to achieve this ‘holy grail’ of market timing, but I feel it still remains elusive.

Generally there are two recognized methods of stock analysis – fundamental analysis and technical analysis.

This type of analysis centres on the business metrics of a particular company. Based on an array of 26 financial ratio’s the analyst is comparing company performance against competitor an.

How to tell when the Stock Market is on Sale

In a recent article in this Investing series, I mentioned that the S&P500 index had delivered an annualized return rate of a little over 11% (7% after inflation) for the past sixty years.

But what caused that generous rate of return? And is there any way to know if the market is likely to return a similar, or drastically higher or lower rate during our own investing lifetimes?

To make a surprisingly educated guess, you just need to understand the formula that determines each individual company’s share price:

Share Price = Company Earnings per share x Price-to-earnings-ratio

The Price-to-earnings ratio (P/E for short) is further determined by these factors:
Earnings growth in recent history x Bullshit Random Estimates of Further Growth

Thus, companies that have recently been enjoying growing profits, and are flashy and exciting and thus expected to see continued profit growth, are rewarded with higher P/E ratios and thus higher stock prices.

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A good example of a currently stylish company is Google, which trades at a P/E of 20 (Google’s shares are worth $500 each, because their earnings per share are $25, multiplied by the P/E of 20)

A less flashy but still very profitable counterexample would be the oil company Chevron. Its share price is only about $100 – earnings per share are $10.30 and the P/E ratio is a nice conservative 9.71. If the P/E ratio were the same as Google, Chevron stock would be worth over $200! This is because investors expect Google to grow much faster than Chevron over the coming years.

But since nobody can really predict future earnings of a company more than a few months in advance, the Bullshit Random Estimates factor is subject to revision each and every day, which is why the stock market fluctuates so wildly.

Luckily, when you’re looking at the whole collection of 500 large companies, over a period of many decades, you can see a much more sensible pattern. An average P/E ratio makes itself visible, which turns out to be the number 16.4. They get this number by calculating a weighted average of the P/E ratios of ALL the 500 companies in the S&P500 index.

So, you could say that when the stock market P/E ratio is above 16.4, it’s unusually expensive. When it is below this number, it is ON SALE! You can of course dig deeper into the details and find exceptions to this rule, but a detailed statistical analysis of the market history shows that if you can buy the stocks when they are on sale way below 16.4, your next 10-20 years of investment returns are unusually good. If you buy when it is way higher than 16.4, you are likely to get lower-than-average returns.

This is because in the long run, company earnings and dividends tend to grow at a fixed rate – the same rate as the entire US economy, which has been about 3.3% after inflation for most of modern history. If you buy a stock which pays a 2% dividend, and its earnings grow at 3.5% per year, and the P/E ratio stays the same over time, it turns out you will get a 5.5% return after inflation (8.5% or so before inflation) on that stock. But if the stock market temporarily goes in or out of fashion and the P/E ratio rises or falls, your return can much be higher or lower. From the 1950s to the year 2000, the P/E ratio went up quite a bit, which provided great returns for investors over that period.

In the Dot-Com peak of March 2000, the S&P index was teetering at a dramatically high P/E ratio of over 30. In March 2020 ten years later, the companies were actually earning MORE money, but the stock index was worth about 30% less. That is because people were less euphoric over stocks at the time, so the P/E ratio was much more realistic in 2020.

In March 2009, there was a massive stock market crash and the stock prices fell so low that the P/E ratio was only in the 13 range. A level of bargainville that hadn’t been seen since about 1986. If you bought stocks back then, you are already up about 100% in two years because both earnings and the ratio (investor enthusiasm) have grown.

So what is the current P/E ratio of the index? It is the current price (1280) divided by last year’s total earnings per share for the companies ($78.86). Giving a ratio of 16.23 – right around the average.

So the stock market is right where it should be, historically speaking, and if this ratio persists, you will get a return equal to US GDP growth plus the current dividend yield that the stocks are paying right now: 1.83%. That adds to 6.83% before inflation. If, on the other hand, P/E ratios go higher due to enthusiastic investors pouring back in as they did in the 1980s and 1990s, you may get lucky – if you are doubly lucky enough to know when to cash out some of your gains into more stable investments before everything reverts back to the mean.

I still don’t recommend trying to outsmart the stock market by timing a repeated series of buys and sells. But I still like following this evaluation method to determine if I’m crazy to add more to the stock portfolio at any given point in time. When the market strays quite far from the mean P/E ratio, that’s something to get excited about.

Help! The Stock Market Is Down

Advice for handling big drops in the stock market

Hinterhaus Productions/Getty Images

When the market is in a down cycle, it’s normal to feel anxious about your 401(k) or other retirement investments.

Should you worry about what the market did today? The answer depends on several factors, including your proximity to retirement, your tolerance for risk, and your skill and experience with stock analysis.

Long-Term Investors and Stock Market Dips

If you are more than 10 to 15 years from retirement and investing for the long-term, you probably don’t have to worry about what the market does on a given day.

The key to long-term investing is defining your risk tolerance beforehand and building a portfolio that you are comfortable with. It’s called asset allocation, and once you’ve settled on it, you don’t need to worry unless your allocation gets completely out of whack.

Many financial professionals will tell you that asset allocation and regular portfolio rebalancing is the best long-term strategy. There’s less fretting involved.

Instead of randomly following the market, you can set a date once a year to check in and see if your portfolio is still in line with your goals. If not, then rebalance.

Rebalancing involves selling winning investments to put more money into investments that have gone down, also known as buying low and selling high.

Say you have a portfolio that’s 70% stocks and 30% bonds. If bonds have a great year and stocks fall, your balance will change. If bonds begin to represent 37% to 63% for stocks, you can move more money into stocks to rebalance.

If you are following this strategy, you don’t really pay attention to the market for the rest of the year. Ups and downs will happen, but if your asset allocation is on target, you can ride out market swings. 

What to Do If You’re a Near-Term Investor

You may have a greater percentage in fixed-income or dividend-paying investments in an attempt to increase the income that your portfolio produces. But once you have an allocation that works for you, the rebalancing strategy is the same as a long-term approach.

Try to check in on your portfolio more than once a year. In doing so, you may decide to make a move if the market goes down more than a set percentage or dollar amount. This is known as a “trigger.”

Some brokerages allow you to set up text or e-mail trigger alerts and will contact you in the event of a price movement, so you don’t have to think about it until then.

One of the age-old rules of thumb for asset allocation in a near-term portfolio is subtracting your age from 100, putting your age in bonds and the rest in stocks. This may work for conservative near-term investors. 

How much risk you want to take with stocks depends on your own appetite for growth and tolerance for risk. You can find many risk tolerance calculators on the web, and your 401(k) administrator probably has some tools to help you.

You can also consider whether you want to keep the stock portion of your portfolio in one broad market index fund or divide your holdings between mutual funds or ETFs, which represent different market segments and sizes, and individual stocks.

Short-Term Investors and a Down Stock Market

In general, short-term investors enjoy watching the stock market on a daily basis. Most people don’t. But if you do love it, you might make money doing short-term buying and selling individual stocks and other securities.

Don’t risk your retirement money on short-term investing until you are very sure of yourself, as the potential for losses is more probable than what a long-term investor would see.

To avoid exposing your retirement accounts to risk, you could build a “fun money” portfolio for stock trading. You’d fund this portfolio with money you don’t mind losing and is separate from your retirement account.

Another short-term, high-risk strategy is to attempt to time the market. Investors who have the most success typically buy rather than sell on market dips.

Of course, this all depends on the health of the company behind the stock. Active traders should learn how to analyze stocks based on the business’ fundamentals. If the company has strong long-term prospects and is a good value, buying it when it’s cheap is like finding a great bargain.

Real short-term or “day traders” have all sorts of tricks, like shorting stocks and making a lot of intra-day moves. Again, unless you really know what you’re doing, you could lose a lot of money attempting this (and even when you do know what you’re doing), especially if you use leverage, or debt, to trade equities. There are also tax consequences to these trades.

The Bottom Line When the Stock Market Is Down

If you’re a decade or more away from retirement, you’re probably able to ride out stock market dips because of your asset allocation and long-term plan.

Conservative near-term investors may not feel the sting of a market drop as much as more aggressive investors.

Short-term investors stand to face the sharpest losses amid a market dip, as their investment choices tend to expose them to higher levels of risk.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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