Friday, October 9, 2009

It's Up! It's Down! It's Cheap! It's Expensive!

If you listen to the business news, a myriad of market pundits are shouting,
  • "Beware!  The market has gotten ahead of itself!"
  • "If you don't get in now, you'll miss this upturn!"
  • "The market is getting very expensive here!"
  • "The market is historically very cheap!"
  • "Buy gold!"
Who's right?

Well, as always, I think the best judge of that is you.  All you need is some information, and you're likely to make a much better decision with your money than anyone who has an agenda.

I.  What do we mean when we say "the market?"

Many of you have heard of the Dow Jones Industrial Average, often called the "Dow."  The Dow is thirty companies (3M, AT&T, Alcoa, American Express, B of A, Boeing, Caterpillar, Chevron, Cisco, Coke, Disney, DuPont, Exxon, GE, HP, Home Depot, IBM, Johnson & Johnson, Kraft, McDonalds, Merck, Microsoft, JP Morgan, Pfizer, P&G, Travelers, United Tech, Verizon and Wal-Mart.)  Since there are about 5000 publicly traded companies, so this is a rather small snapshot.

A much better measurement of the market is the Standard & Poor's 500 (S&P 500), which are 500 large publicly traded stocks, most of which are based in the US.  Let's use this much broader index when we refer to the market.

II.  What is a P/E?

A P/E is a fraction which consists of
  • The Price of the index as the numerator, and
  • The Earnings for that index as the denominator. 
The S& P 500 index is now trading at 1067.59.  That's the P.  It is projected (by Standard & Poor's) to earn $69.20 next year.  That's the E.  1067.59 divided by 69.20 is 15.42.  The P/E of the market is 15.42.  That means that for every dollar the market earns, you are paying $15.42 when you buy the index at this price.

Last year, the P/E was 28.37.  The market was trading at 1099.23, and it earned $38.74 over the last twelve months.  The market is cheaper than it was last year, but you knew that. 

The real question is what is a "normal" P/E?  The historic long term average for the S&P 500 is 15.82.  So, this index is cheaper than its long term average.

III.  The Market is Ahead of Itself

Let's see if people who say this are right.  At its low last March, the S&P 500 traded at 666.79.  It is now
  • Up 60% from its low of 666.79 last March, and
  • Down 30% from its high of 1564.74 in October, 2007
It's trading very near a "normal" P/E of 15.82.  People who think the market is ahead of itself think that times are not normal.  We have a huge deficit.  We have high unemployment.  We are coming out of the worst recession since the Great Depression.

These people may be right, except for one thing.  The market is a discounting mechanism.  That means it is priced for events about 6 - 9 months in the future.

Do you think things are getting better?  Do you think we're on the road to economic recovery?  If so, the market may be fairly priced (but not the bargain in was in March).  If not, you probably think it's come too far too fast.  Your opinion is as good as any.

IV.  If you don't get in now, you'll miss this upturn.

If the best reason you can give for doing something now is that prices will go to the moon if you don't, then you're using the same reasoning that people used to buy Internet stocks in the late 1990's and houses in this decade.  It's not a good reason to buy.

V.  Buy gold

Gold is, historically, a TERRIBLE investment.  What it is, however, is a hedge, and insurance policy against disaster.  If currencies lose value (like our dollar has in the recent economic meltdown), people rush to gold as an internationally accepted commodity. 

If you think the US economy is going to hell in a hand basket, buy gold.  Otherwise, it's ridiculously expensive (an all time hight of $1050 per ounce), and is much more likely to go down over the long term than it is to go up.

So, there you have it.  You have all the information you need to be a pundit.  Draw your conclusions based on the facts, and act accordingly.

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