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Why it's (finally) time to buy stocks

"Investors Business Daily published a great article today on how overvalued stocks had gotten over the past decade and how valuations are finally reasonable enough that investors who buy today can expect to get a great return over the next decade. Anyone who has completely pulled their money out of the market and is still sitting on the sidelines should definitely check it out:

Why it's (finally) time to buy stocks

I find the article particularly interesting because it contains an interview with Yale economist Robert Shiller (of Case Shiller home price index fame). After watching an impressive television interview with Mr. Shiller, I went out and bought his new book "The Subprime Solution" and started reading it last week. I can't really comment on the book yet because I haven't gotten very far into it yet. However, I can share some of Shiller's quotes from this article.

"'If you buy now and wake up in 10 years, you'll probably get a return around the historic average,' said Yale economist Robert Shiller. In the near term, however, Shiller - who correctly predicted the implosion of the stock-market and real-estate bubbles - is more cautious. 'There is a substantial risk that with all this economic turmoil, stocks will fall far lower,' he warned."

Because earnings can fluctuate so much, making P/E ratios look unrealistically attractive during boom times for businesses and unreasonably bad during lean times, Shiller suggests looking at a 10-year average of inflation-adjusted earnings to calculate an adjusted P/E to smooth out the peaks and valleys in profits.

From 2003 through 2006, companies' profits soared to an unsustainable 12% of GDP (from 9%), making their P/E ratios look much more attractive than they really were. Here's how out of line with history P/E ratios had gotten. From 1890 to the early 1990s, the average P/E ratio calculated using the Shiller method was 14.6. During the Tech bubble in early 2000, the P/E soared to 44. Even after the massive subsequent collapse, the P/E only fell to 25 to 28. Now that the market has fallen by another 40%, Shiller's P/E ratio is much closer to its historic average 15.7.

So while stocks may fall a little further from here, using this methodology this is the best time in the past decade to buy stocks. Sitting on the sidelines and not buying now is like paying full price for clothes at your favorite store for nearly a decade but waiting to buy anything new when they have a huge 40% off clearance sale in hopes that they might bump up the sale up to 50% off. Unless you honestly believe that this is the end of the world you need to be averaging into the market right now.

So how much can one expect to make buy purchasing stocks today? The article claims around 9% on average:

"From today's levels, what can we expect? Stocks' future return is closely related to the inverse of the P/E, also known as the earnings yield. So at a P/E of less than 16, investors should obtain real, or inflation-adjusted, gains of around 6.5%, which is about what Asness found in his research. Add 2.5 points for inflation, and the nominal return comes to a respectable 9%. That's about a point below stocks' long-run return, but it's far better than anything investors could expect for a decade and a half."

And here's a plug for buying stocks that pay solid dividends, as I have been advocating:

"The rub is that getting even that 9% return won't be easy. Assuming no escalation of P/Es, stock returns come from a combination of earnings growth and dividend income. Earnings per share grow only at about 2% a year after inflation. (Total earnings grow faster than that, but new issues of stock dilute that growth.) So add in our 2.5% inflation rate to 2% real growth, and you still need a dividend yield of 4.5% to get to that 9% goal. The yield on the S&P 500 is now around 3.3%, versus around 2% earlier this decade. That's better, but not enough.

So simply buying "the market" at today's decent valuations isn't enough. You also need to choose stocks that pay higher-than-average dividends to reach the 9% threshold. Fortunately, that's not too difficult to do now. Lots of stocks with predictable, reliable earnings streams now offer yields between 4% and 6%, including Consolidated Edison (ED), Kraft Foods (KFT), Duke Energy (DUK), and Merck (MRK)."

I strongly believe that investors who continue to feed money into the market a little at a time right now will be very glad that they did in several years."

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