Sunday, 19 October 2008

Is It a Good Time to Buy?

After global markets have been battered, investor Warren Buffett is telling everyone to buy. The argument is that the panic selling was irrational and because of irrational selling the market is undervalued. The companies themselves are sound but the price has been discounted too far.

However, is this true? If the gloomy news about lower profits and credit freezes are true, then companies may not be fundamentally sound. One measure of a company is the price-earnings ratio, a measure of whether a company's stock is overvalued or undervalued. The problem with the PE ratio is that past earnings are used to calculate this ratio. In the past earnings may have been great because our economy was booming. However, with the credit freeze and looming recession, who is to say earnings won't go down? Maybe the market is rational if it reduces price in line with what is expected to be a reduction in earnings.

Nevertheless, I was looking at Wikipedia today and Robert Shiller has created a nice scatterplot showing how investing in companies with PE ratios of 10 or below gave the best returns.

In my opinion, the inherent value in shares comes from its dividends since earnings reports can be fudged by unethical accountants. The long run average price-dividend ratio for the S&P500 is 24.

This empirical evidence suggests that a contrarian investment strategy (similar to what Buffett suggests) is best. You go all-in to stocks when the market has low PE or PD ratios and you hold back (set aside more in cash) when the market has high PE or PD ratios. Of course, if everyone sees this opportunity to profit and employs this contrarian strategy, then the contrarians will become mainstream and then being contrary won't be contrarian anymore. I was talking with some friends before and one of them said, "Now is a great buying opportunity because stocks are do cheap. You should buy when everyone else is selling." However, another friend, a successful full-time day trader, replied by saying, "I am selling now because I am contrarian. There are plenty of irrational buyers still out there that I want to exploit." So as you can see, while there may be plenty of bulls who look for opportunities to buy low to exploit irrational sellers, inversely there are many bears who look for opportunities to sell high to exploit irrational buyers.

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