back to blog homepage

Step #3 In Detail

Last week, I posted about Gambling Vs Investing and gave you a step by step guide on how to be an investor.  I’ve had some questions about parts of the process, so I thought it would be a good blog post to discuss some of those steps in more detail.  So, I thought we would start with Step #3 since steps 1 and 2 deal with deciding to buy a stop and choosing one to research.

“Step #3:  examine the macro issues impacting the stock:

·   is the stock market itself in a bull phase or a bear phase;

·   do you believe from a timing standpoint that now is a good time to buy ANY stock;

·   is the industry within which the company operates in a bull or bear phase:

·   are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)”

Examine the macro issues impacting the stock provides you a big picture overview.  There is an old investment saying “A rising tide lifts all boats” that applies here – meaning that if the stock market itself is going up, then all of its participant companies have a force pushing their stock prices higher.  However, the opposite also applies as a falling stock market will take prices of good companies down along with bad ones.  What you want to do is determine which way the tide is flowing in order to know if your timing is right to buy from a macro perspective.

How do you do that?

  • You can look at the valuation of the market and see if its overvalued or undervalued
  • You can look at the trends to see if it is trading above or below its moving averages.
  • You can look at breadth to see how many companies are moving along with the price of the market
  • You can look at sentiment so see if investors are euphoric or frightened

Today, lets focus on valuation and figuring out where we are in the macro picture.  A future blog post will look at trends, breadth and sentiment.

I have a number of ratios I calculate and indicators I follow that tell me this, but as in individual investor you have more limited time and access to information than I do as a professional.

So the easiest things you can do are:

  • Look at the P/E Ratio of the S&P 500 Index and see if it is trading below 10 (extreme undervalued) below 15 (undervalued) or over 20 (overvalued)
    • I could go thru the calculation for you, but the Wall Street Journal is nice enough to just tell you what the current P/E ratio is today compare to a year ago, so you get a picture of the trend – a P/E Ratio that is higher today than a year go tells you that the stock market is more expensive today than a year ago so some caution is warranted.
      • https://www.wsj.com/market-data/stocks/peyields
      • From the table below copied from this link, you can see today’s P/E of 43.92 is materially higher than last year’s 26.10
    • Since 43.92 is above 20, this simplistic measurement tells you the market is overvalued.

1

Double click on any image for a full size view

  • Apply the Rule of 20 to determine the timing:  the sum of the S&P 500 P/E Ratio based upon estimated earnings for next year + the Projected Rate of Inflation must be less than 20
    • We know that we can get the P/E ratio from the WSJ link above, but they are also kind enough to provide you with the P/E Ratio based upon next year’s estimated earnings, or in this case 22.71.  This is already over the Rule of 20 threshold for overvalued, but roll with me…
    • We also need to know the Projected Rate of Inflation to complete our formula.  Again, our friends at the WSJ provide this data for you
      • https://www.wsj.com/graphics/econsurvey/?mod=nav_top_subsection    Once you navigate to this page, just choose CPI along the left side of the page in the Economic Indicators section
      • From the table below, you are given choices on timeframes for the projection.  I usually use the 6month projection since that is the average number of months overwhich our earnings projection covers.  There is no science here, just use one of them and you will be close enough, but make sure you have a basis for your selection
    • Our Rule of 20 calculation yields 22.71 + 2.8 = 25.51, or a number greater than our threshold of 20

1

  • Compare the total value of the US Stock Market to the output of the US economy.  This is Warren Buffet’s favorite indicator for determining if the stock market is overvalued or undervalued from a macro standpoint.  You can do the research to figure out the total value of the stock market and the current reading of GDP (the measure of economic output), but I cheat and go to the gurufocus website and they provide the information for me – you just need to the the “X” at the bottom of the log-in pop-up screen to access it
    • https://www.gurufocus.com/stock-market-valuations.php
    • The chart they provide gives you a visual that is easy to follow – looking at it below you can see that the stock market is significantly overvalued compared to the economy and that they overvaluation has grown wider over since it was last on par in 2009

1

 

They also provide us with this chart that bring the graph relevance:

1

 

Why is valuation at a macro level important?  Because today’s valuation helps determine your future returns.  Again our friends gurufocus provide us a graph that explains this.

1

This is a busy graph, but it shows that the mover overvalued the market, the lower the forecast future returns are for the stock market.  This graph shows you that the most significantly overvalued level shown (i.e., the ratio of the value of the stock market to GDP) is 130%, leading to a projected negative 7% forward return.  They do not calculate the forward return when this ratio is at 195% (see the chart above) but the forward return would logically be significantly lower than negative 7%.

However, let me stress this point:  this is not the Bible, its more like government ethics – it is a guideline that is rarely adhered to by the stock market.  There are two factors to remember:  (1) this really only applies if you are a buyer of the broad stock market TODAY; and (2)you can find companies to buy today that will return significant profits for you in the future, even if the broader stock market has a negative return over coming years.

Don’t let this analysis convince you to sell everything you own simply because these guidelines provide an answer that is not pretty.

Do, however, let these calculations tell you that from a macro standpoint, now is not the best time to be a buyer of initial or expanded stock market exposure – there will be a time when the market is more supportive than it is right now of expanding your allocation to stocks.  You can use these tools to help you determine that, or you can hire a professional to do the work for you.  I believe the right answer is to hire a professional that understands this stuff – not all do, some will tell you that the market is set to go higher indefinitely, you can watch them on stock bubble television all day long, but that is not reasonable or logical – and let that professional use the tools in their toolbox to determine when the macro environment says to be a buyer.