There are two different theories when it comes to investing. Some people like to buy and hold, letting time be on their side to rack up gains in the market. Other people prefer to actively manage their accounts trying to buy low and sell high. Both work and it all depends on how much effort you want to put into your account. By understanding what to look for in the stock market you can determine if it is undervalued and thus primed for you to buy.
Low P/E Ratios
One of the biggest things analysts look at in stocks is their price-to-earnings ratio. If a stock is selling for $40 per share and the company posts earnings of $5 per share, their P/E is 8. When looking at the market as a whole, one has to watch the movement of the P/E ratios, often done by analyzing the CAPE ratio.
Like the P/E ratio, the earnings yield measures the earnings of a company. However, it is the inverse of the price-to-earnings. So in our example above the P/E was 8, therefore the earnings yield would be 1/8, or 12.5%. A higher earnings yield means the stock is more undervalued.
Bud Conrad’s Yields Comparison
By comparing the earnings yields of the S&P 500 to the yields of 10-year treasury bonds, you can get a fairly accurate outlook for the market. When the market yields are higher than those of the 10-year treasury bonds, the market is undervalued. This is good news for us now, because treasury rates are at near record lows. Unfortunately, they can only go up from here.
Yield on Treasuries Is Dropping
After a recession the Fed will cut interest rates. This helps companies have easier access to cash and keeps money moving in the economy. However, if the rates are not raised back up, inflation can skyrocket. When the rates are dropping, the market is undervalued. The easier access to cash will help to boost the market.
Financials Are Looking Good
This process requires a bit more leg work, but can help you to better understand the correlation between stock price and the company. Using Yahoo and Google you can get the financials of the company. You can see how much they had in earnings, how much debt they have, and read all about their P/E ratios. The point is that a low P/E ratio means nothing if the company is swamped with debt and on the verge of bankruptcy.
Bonus: Media Hype
There is another way to pick up stocks at a low valuation. While not as scientific or mathematical as the other methods it involves watching the media. A little bit of bad news about a company will cause many investors to flee. This is your cue to swoop in and pick up stocks cheaply. For instance, several years ago the CEO of Yahoo refused to sell the company. Overnight the Yahoo stock dropped nearly 10%. I purchased as much as I could in the morning, and by lunchtime the stock had recovered 5% of the loss.
Buying low and selling high is the goal of all investors. The key is being able to know when the market is low (undervalued) and when it is high (overvalued). It does take some time and research, but anyone can do it. However, it is perfectly reasonable to leave the active management up to the experts by buying and holding mutual funds. The one warning in that situation: do not move your money based on emotion, you will lose the majority of the time.