What to buy when markets look expensive
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MoneyWeek Editor
John Stepek Apr 01, 2010
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The US market took a bit of a knock yesterday. Unemployment data was worse than expected, just as everyone was getting into full-blown recovery mode.
We'll have more on that below. It wasn't actually too bad a knock. It certainly wasn't enough to put a dent in the rip-roaring returns seen since the start of the year.
The market is up nearly 5% over the past three months, its best first quarter for 12 years, according to Marketwatch.
So the market is still in full-blown bull mode. But it's also still expensive...
Poor US jobs data has done little to worry climbing global markets
US jobs data disappointed investors yesterday. Payrolls firm ADP said that 23,000 jobs were lost in the private sector in March. That was the smallest monthly loss since February 2008. However analysts had expected a rise of 40,000.
It dented confidence a little. Investors have been getting excited about Friday's all-important payrolls data from the Department of Labor. That's expected to reveal that the US economy added 200,000 jobs last month.
That sort of growth may still happen. After all, ADP data doesn't include public sector jobs. Hiring for the US 2010 census is expected to add 100,000 jobs to the economy.
But if you're wondering why investors should get excited about a load of temporary government jobs being added to the nation's payroll, you're not the only one. After all, these jobs are just paid for out of taxes, future or present.
The fact that small businesses – which are arguably the most important wealth-creating machines in a country – are still shedding jobs in their thousands, is a much more worrying phenomenon.
But right now the market's not in the mood for fretting. The S&P 500 – along with global markets generally – has continued to climb. In fact, as Dylan Grice of Société Générale points out, it's now climbed so far that it's well into over-priced territory.
How to tell if stock markets are overpriced
Based on the Shiller p/e ratio, the S&P 500 is now into its "top historical valuation quintile". The idea behind the Shiller p/e is that you take earnings over ten years, rather than just one. This gets around the fact that earnings for many companies are cyclical – they rise when the economy is doing well and fall when it's doing badly. Take a house builder for example. When it's boom time, builders get to sell a lot of houses, at ever higher prices. So their earnings – the 'e' side of the equation – go up. If the share price – the 'p' bit – stays the same, the p/e ratio will fall.
This might make the house builder look cheap compared to current earnings. But how long can those earnings last? If there's a housing crash – or even just a drop-off – around the corner, then earnings will tank. So the standard p/e ratio isn't especially useful in this case.
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And that's where Shiller's p/e comes in. To cut a long story short, the lower the p/e when you invest, the better you can expect your returns to be over the following decade. And if past performance is any guide at all, then if you buy the S&P 500 now, you can expect a less-than-whopping 1.7% annualised real return over the next decade. Hardly bargain territory, you'll agree.
Of course, on the Shiller p/e measure, share prices never really got cheap. Even by the low in March 2009, they had only hit fair value. This is one of the main reasons why we've been largely tipping defensive stocks rather than the wider market. With so many weak points in the global economy, and so much reliance on government intervention to keep markets afloat, we'd rather play it safe than take big stakes in the companies most exposed to an unexpected new disaster– be it a sovereign default, inflation, or interest rates rising faster than expected.
What to buy when markets look expensive
So what can you do when stocks look expensive? Well, Grice points out that one option is to do nothing. It's a view shared by his former colleague James Montier. As Montier points out in his Little Book of Behavioural Investing (which is easy to read and highly recommended, particularly if you're pushed for time), it's in our nature to always be "doing something". But unlike fund managers, individual investors have no 'career' risk. You don't have to worry about being measured against the index. So there's no need to pile into a market just because everyone else is. (My colleague Tim Bennett reviews more of the mistakes highlighted by Montier in the current issue of MoneyWeek magazine: Five common mistakes to avoid).
But it's one thing saying all this and quite another to put it into practice. You might well be thinking right now – "yes, yes, I know all this, but just tell me what to buy". And the other point that Grice makes is that even if the broader market looks expensive, there's "usually something going on at a micro level." In his latest report he includes a list of stocks which still look inexpensive based on their ability to add value for investors (you can find out more about his method here: How to find a balance sheet bargain).
Among the names on Grice's list is US drug giant Pfizer. My colleague David Stevenson also reckons it looks cheap, as he pointed out last week. And we've more on why US pharma stocks in general look worth buying now in this week's issue of MoneyWeek magazine, out tomorrow (if you're not already a subscriber, claim your first three issues free here).
Our recommended article for today
One way for the Government to pay off its huge debt is to inflate it away, says Bengt Saelensminde. Here, he explains how you could do the same for your mortgage.
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