10% Down, 20% Cheaper
How to cope with Mr.Market's moods...
AFTER two years of seemingly never-ending advances – with very few shallow pullbacks – the market has entered correction territory in record time, writes Zach Scheidt in Addison Wiggin's Daily Reckoning.
It reminds me of a quote from investing legend Warren Buffett:
"For you see, Mr.Market is emotionally unstable. Some days he is cheerful and enormously optimistic...At other times, Mr.Market is discouraged and terribly pessimistic..."
If Buffett's analogy for the stock market rings true, this is definitely one of those times when the market is "discouraged and terribly pessimistic."
But ironically, that's good news for you today. In fact, the news is even better than you may realize!
New investors may be unfamiliar with the idea of the market pulling back sharply over a week or two.
But if you've been tracking your investments for more than just the last decade, you know that when the market corrects, it's actually a great time to take advantage of "discouraged and terribly pessimistic" traders.
All you have to do is buy shares when the market is discouraged and sell them for a profit when the market becomes cheerful again.
Obviously, easier said than done.
But after this month's pullback, you've got an extra reason to buy stocks that are currently on sale. You see, not only are stocks cheaper after the market's pullback, but they're also more valuable!
It's not often that investors get this kind of opportunity. Usually, when stocks are pulling back by a significant amount, it's because investors are worried about lower profits and a shrinking economy.
That's not what is happening in today's market.
Instead, investors started selling out of concern of rising inflation. And then as we discussed last week, the financial "weapons of mass destruction" kicked in, triggering a domino effect of selling.
But the falling stock market is actually very disconnected from the overall picture for the economy and for individual companies.
As companies report fourth quarter earnings for 2017, and management teams release guidance, expectations for profits this year keep climbing higher.
Which means the true underlying value for the stocks is increasing – at the same time the stock prices are decreasing. So as an investor, you're getting much more for your money if you buy shares of quality companies right now.
Remember those "double value deals" McDonald's used to offer? Well, today, the market is making a similar deal with investors, offering twice the value you might expect from this kind of pullback.
According to Bloomberg data, the amount of extra value you're getting when you buy stocks today far exceeds the value you were getting just two weeks ago. And this value can be scientifically measured using a key statistic that professional investors follow.
The price/earnings ratio – or PE ratio – is simply a measure of how much investors have to pay for every Dollar of earnings a company is expected to generate. A high PE means stocks are expensive, and a low PE means stocks are cheap.
Before the market correction, the average PE for the S&P 500 index was just over 20. That means you had to pay $20 for every Dollar of earnings a company was expected to earn.
Now the market pulled back by roughly 10%. So it's natural to assume that the average stock's PE dropped by about the same amount.
But don't forget about the higher earnings expectations!
You see, at the same time stock prices were dropping, earnings expectations were increasing. That's because of the strong economy, tax cuts and other factors that are boosting 2018 profits for US companies.
With earnings expectations growing, and stock prices falling, both sides of the PE equation have been quickly moving in our favor.
And so, as of mid-February, the market's PE – or the cost that you have to pay for every Dollar of expected earnings – dropped from above 20 to below 16.
In other words, you're now getting a 20% discount on stocks. Nearly twice the discount you may have thought when you looked at the market's pullback.
In short, this is a great time to be picking up shares of quality companies with growing earnings and cheap stocks. I can't promise that stocks will immediately move higher from here. But I believe you're getting a terrific value at today's prices