If investing is all about buying low then selling high, then the price paid for any particular stock is the most-important and often dominating factor in its ultimate price-appreciation success. The surest way to make profits in the stock market is to buy good companies at low prices.
Low and high stock prices are not defined by absolute share levels, which are irrelevant. A $10 stock can be expensive while a $100 stock is cheap. The key is valuations, or where any stock price is trading relative to its underlying company’s earnings stream. The lower any company’s stock price compared to its profits, the cheaper it is. The more earnings investors can buy per dollar of share price, the better.
This concept is so simple, yet most investors foolishly choose to ignore the valuation price they are paying. Imagine buying a house as a rental property, with expected annual rental income of $30k. If you can get that house for $210k, 7x earnings, it will pay for itself in 7 years. That’s a great deal! But if that same house is priced at $630k, 21x, it’s a terrible deal. It will take far too long to earn back your investment.
Price paid is everything, yet stock investors don’t hesitate to pay 21x earnings and higher for stocks when the US stock markets’ historical 125-year-average trailing-twelve-month P/E ratio is only 14x earnings. While not only irrational, a century and a quarter of US stock-market history shows this rarely works out well for investors. And the flagship US broad-stock-market index, the S&P 500, is now priced well above that 21x historical expensive level. Such valuations usually signal a major top underway.
One reason investors are over paying is that they are being lied to.
The S&P 500 is also known by its tracker ETF symbol SPY. Comprised of 500 of the biggest and best American companies, the SPX (or SPY) is the best gauge for the broad US stock markets. Across these elite stocks is where market valuations are best measured. And if you pull up SPY in Yahoo Finance, it reportedly has a “trailing-twelve-month” P/E of 17x. That remains far from the expensive 21x level, not a cause for concern. The problem is that is totally false!
I made a screenshot of Yahoo Finance for ticker symbol SPY yesterday:
Zeal Investments, for example, shows how they calculate the P/E ratio:
“At the end of every month feed all the valuation data for each of the 500 individual SPY component companies into a spreadsheet. Then we averaged them all to get the broad-market valuations. As of the end of March 2014, the simple average of all 500 SPY companies’ trailing-twelve-month P/E ratios scraped directly from Yahoo Finance was 25.7x earnings.”
This is vastly higher than the 17x reported for SPY by Yahoo Finance. As you can see from the screenshot, Yahoo Finance’s 17x is “ttm” (trailing-twelve-month) P/E and was updated at the end of March so the number should show something close to a 25.7x P/E, especially since the individual data came from the same source. But it is never close.
That means at 25.7x P/E without earnings growth, it would take between 23 and 26 years for an investor buying an average elite SPY stock today merely to earn back the price paid! History proves that is far too expensive to sustain.
Once again the century-and-a-quarter average P/E ratio for the broad US stock markets is 14x earnings. That is fair value, and it makes sense. The reciprocal of 14x earnings is 7.1%. That is a fair yield for savers to earn for investing their hard-earned surplus capital in companies, and a fair price for “debtors” to pay to “borrow” money to grow companies. Capital changing hands at around 7% is mutually beneficial for all parties.
Wall Street never, ever predicts bear markets, as it is bad for business. Wall Street only recognizes bear markets in hindsight, as it wants to keep investors buying stocks no matter how expensive or risky to keep this industry’s profits high. So the popular mainstream view advanced by Wall Street these days is we are in a new secular bull market. Keep buying, be happy.