Is Market’s Plunge Reason to Buy or Bail? (By the Numbers)

May 05 2010

Is Market’s Plunge Reason to Buy or Bail? (By the Numbers)

Posted by Anthony Walker in Finance News

U.S. stocks were up slightly at one point on Thursday morning just after 10 a.m. in New York, although you might have missed it if you sneezed. Prices then declined slowly but steadily until about 2 p.m., after which the bottom fell out as quickly as I’ve ever seen. Before 3 p.m., the Dow Jones Industrial Average had shed more than 900 points — its largest-ever intraday point loss. The average closed at 10520, down 347, its third straight day of declines.

Looking for explanations, media commentators have focused on mounting concerns over Greece’s debt crisis. That connection doesn’t do it for me. We learned little about the situation this week that we didn’t know last week. Some are questioning what might have been a technical error during trading in Procter & Gamble (PG) shares. It’s remarkable to think that the value of American companies might have briefly dropped by a trillion dollars because of panic caused by a simple mistake.

Of course, it doesn’t help that May is the focus of an enduring, superstitious saying about avoiding stocks during the summer: “Sell in May and go away.” If you’re curious, February and September have been the worst months for the S&P 500 since 1950, with average declines of 0.4% and 0.8%. Summertime has tended to be dull, but not disastrous.

Here’s my theory about what’s happening and whether it’s time to bail or buy.

There’s a lot of money sloshing around in stocks that belongs to people who don’t know or care how expensive stocks should be. That might have to do with the rapid expansion of share ownership from less than 20% of American households in the early 1980s to more than half today. It might also have to do with the rise of set-it-and-forget-it investing. In a 2005 study, researchers from Indiana University calculated that stock-picking in the U.S. as a percentage of overall market volume fell from 60% in 1960 to 24% in the early 2000s. Workers shoveled money into their 401 (k) accounts and, by extension, into index mutual funds (or actively managed funds, which tend to stick closely to indexes), because stocks were hot. But stocks were hot because they were shoveling money in.

That pattern led to two decades of mostly bloated share prices. Over the past 138 years, U.S. stocks have traded at an average of around 15 times trailing earnings. Over the past 20 years, they’ve sold for an average of more than 19 times trailing earnings (and that’s using a modern, more generous way to calculate earnings). The problem has been compounded by the fact that earnings sometimes follow share prices, instead of the other way around; that is, investors sometimes use easy stock gains to justify a trip to the electronics store.

The earnings recovery we’re undergoing has already begun to look less like a recovery to normal levels than a return to the bloated ones of a few years ago. The nation’s corporate profits are already slightly above the average share of the economy they’ve made up over the past 80 years. Far from having turned permanently frugal, Americans in March spent at a pace that dragged the personal savings rate back below 3%, less than half its long-term average.

Thursday’s frantic trading, and the frantic trading in recent years (stocks are much more volatile than they were two decades ago), might be a sign that investors have lost perspective of what shares are worth. They used to have an easy reminder in the form of a dividend yield. When a stock’s stream of quarterly cash payments looked too small next to its purchase price, it was time to sell. But fewer companies pay dividends today — 74% of S&P 500 members, down from 94% in 1980. And some of the most exciting stocks pay nothing. Apple (AAPL) has soared in price to become America’s third-largest company by stock market value, but investors who buy today do so merely on the hope that someone else will pay more, not because they’re being paid a share of the company’s profits. That makes it difficult to know whether even such a prosperous company is fairly priced.

The stock market looks to me to be overpriced by around one-third at the moment. I base that on its trailing price/earnings ratio, adjusted for how normal recent corporate earnings look as a share of the economy. (They look pretty normal and maybe even a smidgen high, it turns out.) There are still some bargains to be found, but there’s no urgent need to put fresh money into the market just because it’s cheaper today than a week ago. If you’re fortunate enough to have participated in the market’s massive rally over the past year and you’re alarmed by what happened Thursday, put bravado aside and do some selling in May, just like the saying goes.

Jack Hough is an associate editor at SmartMoney.com and author of “Your Next Great Stock.”

Wealth Finance