Many people watching the stock market decline are looking for a buying opportunity. However, by most indications this is not yet an appropriate time to invest.
With equity markets down as much as double-digit amounts in some cases, there has developed a feeling that the worst may be over. That viewpoint is reinforced by the recent, sizable cuts in interest rates, coupled with the stimulus package of more than $150-billion provided by the U.S. government. Nevertheless, soon any optimism generated by those moves will fade as economic data points to a weak job market, a recessionary mood in the service sector, and falling consumer confidence.
Spotting the difference between a genuine market low, and a short-lived “sucker’s” rally is a complicated matter. One approach is to look at investors’ sentiment. The best buying opportunities occur when almost all observers are gloomy. Currently, most market anticipants are upbeat, poised to jump in our equity markets.
Can valuations tell us anything useful? When the dividend yield – what companies pay – is higher than the yield on medium-grade bonds, that could be a buying signal. Up to this time, bonds provide a higher return. Also, when shares deliver historically high dividend yields, say about six per cent, that often is a clue about the future. At the moment such triggers do not exist.
Then there are optimists who argue that common shares are inexpensive relative to either trailing or prospective earnings. As a counter-argument others note that corporate profits are historically inflated, and therefore, could have a long way to fall before they reach their usual relationship to gross domestic product. Furthermore, estimates of future earnings are notoriously inexact, with optimism particularly high at the tail end of a boom. One should not put much faith in earnings forecasts, as they usually are the product of stockbrokers who are perennially bullish. Too, we have had three decades of above-average profit growth, and a reversion to the mean is most likely.
While the recent ratio of share prices to earnings is about 16 times present earnings, the same as throughout the past ten years, if one were to go back a few decades, the average price-earnings ratio was under 12 times the then-prevailing earnings. It was even lower than that in 1929 so that standard measurement is not useful.
History shows that there is no correlation between the valuation of a market when down market begins and the subsequent sell-off, the eventual reduced price.
In the end, predicting the length and depth of a business contraction, in theory, could allow investors to forecast the prospects for corporate profits. Regrettably, the severity of a business decline, along with other factors, always remain a matter of conjecture.