When to buy back in

I’m getting ahead of myself today. But I suppose that’s the point. To be ready for the buying opportunity of the decade.

My own attempt to set up and fund an ISA has been delayed. It seems the provider doesn’t have enough staff to verify my supporting documents…

That could be a sign in and of itself. If broker staff are too busy to deal with new clients – what should be the most important and treasured customers – then it might be time to buy into stocks again. At mass pessimism and financial fallout within the broker businesses.

But let’s look at a few more scientific approaches, shall we? When does a bear market bottom out?

One insightful messenger is the P/E ratio. It tells you how cheap stocks are based on earnings. This is a confusing concept, unless you take it to a local business level first, just to explain it.

How much is your local corner store worth? A small business owner would likely suggest around five times its annual profits over the past few years. That’s a P/E ratio of 5.

Well, in the stockmarket, people pay a lot more. Never mind why, but the historical average in the US market is around 15. For every dollar of annual profits, investors can expect to pay a price of about $15.

When the P/E ratio is above this, stocks are expensive. When it goes below, they’re cheap.

Here’s how that P/E ratio has trundled along over time…

S&P500 P/E RatioSource: Seeking Alpha

Based on that measure, we still have a long way down to go in the US markets. Especially with markets usually overshooting on the downside.

I couldn’t find a decent up to date FTSE 100 P/E chart, but this chart shows the FTSE100’s history going back from mid-2018. The trailing P/E is based on past profits. The forward P/E is based on future profit estimates at the time.

As you can see, the P/E ratio would’ve warned you off buying stocks during bubbles and it also told you when to buy back in – when things got cheap again.

Source: IG Markets

A similar signal is the dividend yield of the wider market. At some point, stocks become so cheap that their dividends are worth buying for, even if capital gains look impossible. Of course, that’s just when the capital gains make their comeback…

In 2009, the FTSE100’s dividend yield ticked above 5% thanks to the cheap prices on offer. That was the signal.

We don’t know what impact COVID-19 will have on dividends yet, but keep an eye on the yield. When you’re getting tempted by the cash flow returns, others will be too.

This method works to identify opportunities in individual stocks too. Just be sure to work based off of projected dividends that take into account the COVID-19 crisis.

My third indicator is based on chart analysis.

The first technical analyst I ever worked with, back in 2010, used what’s called “widening distributions” in his trading. It just so happens that our FTSE100 has conformed perfectly to that chart pattern.

This chart shows the FTSE100 going back to 1990. We had a proper bull market to 2000. But since then, we’ve been going sideways in a widening distribution around about the 5000 level. Each bull and bear market has really just been a pendulum swing around this point.

Source: Yahoo Finance

We’re halfway back down to the bottom of the pendulum swing. The widening distribution theory suggests we’ll go as low as 3500 in the FTSE100 – another 30% decline. Unless something kicks us out of the current widening distribution – a proper sea change that launches a new bull market.

This is what real bear markets look like, by the way. Long periods of sideways moving markets, punctuated by bull and bear markets that lead nowhere in the end.

If our 20 year bear market has left you frustrated, consider this. Adjusted for inflation, the Dow Jones Industrial Average traded around 2500 in 1915, 1927, several times between 1931 and 1953 and again in 1982. That’s almost 70 years without capital gains, adjusted for inflation…

DJIA inflation adjustedSource: Macrotrends.net

What, they didn’t mention the 70-year bear market when they told you stocks go up in the long run?

Back to today’s topic. Whether it’s just another bear market’s temporary bull market to the top of the widening distribution, or a proper bull market like that from the 80s, at some point, stocks will turn back up.

I’m going to send out emails asking our other editors what signs they’ll be looking for.

My mentor in Australia mentioned that rising stocks on seemingly bad news stories was his favourite tell-tale sign of a bottom. That’s because the news has become less bad than markets anticipate – the makings of a bull market when the news does actually change for the better.

Do you have any favourite indicators of the end of the bull market?

nickolai@southbankresearch.com

Until next time,

Nick Hubble
Editor, Exponential Investor

Category: Commodities

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