Determining if the market is cheap or expensive

Determining if the market is cheap or expensive

Determining if the market is cheap or expensive is one of the things that every investor should learn. It’s not too difficult to tell when something we buy regularly is on sale or overpriced.  If we see Filet Mignon for $4.00 a pound, it’s probably a pretty good deal.  If we see it for $14.00 a pound, it might not be something we want to put in the cart.

 

Determining if the market is cheap or expensiveUnfortunately, our ability to spot a bargain goes out the window once we start trying to figure out the value of things that we don’t buy that often……especially if those things are high ticket or intangible.

 

For example, one of the reasons people are afraid of ever getting into real estate is that they have no clue whether they’re buying the property at a bargain, or getting themselves into a lot of trouble. There are so many factors from repairs, to taxes, to permits, to school districts.  It could be worth $300,000.00.  It could be worth $500,000.00.  You wouldn’t know unless you did enough deals to get an idea of what the numbers really looked like….or at least had a mentor to guide you.

 

That brings us to the stock market.  The stock market and how we value it is so incredibly controversial that the experts have basically said that there is no such thing as valuing the market.  They believe the market is so efficient, and there’s so much information out there, that whatever the market is priced at is what it’s worth.  No such thing as being on sale or overpriced.  No such thing as fear and greed.  Just spread out your bets (diversification) and shoot in the dark (dollar cost averaging), because trying to time the market is almost impossible…….of course we think this is total nonsense.

 

Value Investing to the Rescue

Robert Shiller, a Nobel Peace Prize winning academics professor at Yale, basically called out the Financial Industry on their nonsense during his career. He came up with a nifty way of determining whether the market is cheap or expensive.  It’s called the Shiller P/E and it basically measures the price of the market as it relates to the averaged 10 years earnings of the underlying companies.

 

This is really what value investing is all about.  It’s the idea that something shouldn’t be valued with arbitrary sentiment.  It should be valued by its ability to produce cash flow.  If you were to buy a hot dog truck for a $100,000.00, would you want the hot dog truck that makes $3,000.00 in profit annual?  Or would you want the one that makes $25,000.00.  One will take over the 30 years to get your initial investment back.  The other will pay you back in 4 years.  Pretty simple right?

 

What the Shiller P/E tells us is how many years investors are willing to wait  in order to make their money back in earnings. What Robert Shiller found was that any time the Shiller P/E went above 27, it was likely to be followed by a significant sell off, or even a crash. 1929, 1987, 2001, and 2007 were all very significant years as they were the peaks of the market which preceded major stock market crashes.

 

Studies also showed that any time the Shiller P/E was in the teens or even single digits, the stock market was a real steal that created far above average returns for the investors that bought in.

 

The Danger Zone….

As I’m writing this post, right now the Shiller P/E is reading about 29.5.  The only 2 periods it ever reached this level was on Black Tuesday preceding the Great Depression, and the Dot Com Bubble followed by the crash in 2001.

 

Thinking of it from a business perspective, investors are paying $100,000.00 for the hot dog truck that makes $3,000.00 a year.  It’s pretty silly, and there isn’t any business reason behind making an investment like that.  There’s only the hope that the market will go even higher in order to sell at a profit.

 

The real challenge in being a value investor is being able to go against the tide.  As Warren Buffet would say,  “Be fearful when others are greedy, and greedy when others are fearful.”  That takes patience, discipline, and a clear understanding of what it is you’re buying into.

 

Not sure how to invest in a market that could go at any moment?  We have strategies for all markets.  Take a look.

 

About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

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