Many popular investment “gurus” advocate the Buy and Hold Strategy, yet most never discuss valuation. We believe that valuation matters most, so before we look at anything else, we determine whether an asset class is currently cheap, expensive or fairly priced. If you pay too much for an investment, all the time in the world won’t fix it, even if you just invest in an index fund. The chart below shows the S&P500 adjusted for inflation from January 1, 1873 to January 1, 2010.
This chart shows that if an investor purchased the index in 1966, they would have waited until 1991 for it to return to the same value! For twenty five years their investment was underwater. This chart also shows that we have yet to come close to the high reach at the turn of this century.
So how can an investor know that in 1966 or in 1999-2000, the S&P was overpriced? One way is using the price to earnings ratio (PE). The chart below shows the PE ratio for the S&P for the same time period. The PE ratio be thought of as how much an investor is willing to pay for one dollar of earnings. A PE ratio of 20 means that the market in aggregate is willing to pay $12 for $1 of annual earnings.
This shows that in 1966, the PE ratio reached a high near 25 and in around 2000, the S&P again reached a high of nearly 45! This is just one measure of valuation that we use to help us determine if the stock market in general is over-priced, under-priced or fairly priced. The mean PE ratio is 16.35 and the median is 12.87. The lowest PE ratio occurred in December of 1920 at 4.78 and the highest PE ratio so far was in December of 1999, when the ratio reached a mind boggling 44.20.
On 1/1/1982, the S&P PE ratio was again at a historical low of 7.4 and the inflation adjusted S&P was at 268.62. If an investor purchased the S&P index at this point, and kept it until the PE ratio reached 43.8 on 1/1/2000, the S&P had risen to 1,823.78, which means the investors after inflation average annual return was 11.23%. Compare this to the 25 years it took from 1966 to 1991 for an investor to simply get a return of their initial investment and clearly, valuation matters and buy and hold provides little aid for an over-priced investment.
We don’t believe we can time the market. There was no way to know that the PE ratio was bottoming out in 1982, nor could we know in December of 1999 that the market had peaked, but we could see that in both cases a directional change was bound to occur. We don’t believe we can get the timing exactly right, but we do see opportunities, both for gains and losses when valuations are above or below historical norms.
By the way, we currently believe that the S&P is again relatively over-priced. If you remove the insanity that occurred around the turn of the century, the chart above shows that the PE ratio is again near historical highs.