The Investment Scientist

Archive for July 2008

It’s official. On July 9, US stocks slid more than 20% from their October high, sending the S&P 500 into bear market territory. Even earlier this month the NASDQ and Dow Jones turned bearish following the Russell 2000, an index of small caps, which lead the decline.

How long will this bear market last?

Well, I don’t have a crystal ball, but I do have a rear view mirror.

Since 1960, there have been ten bear markets (see Table). The worst bear market took one-and-a-half years to reach bottom. Four reached bottom within a month. The remaining five hit bottom between one and ten months. On average, it took 4 months to reach bottom.

Date of entering bear market Months to bear bottom 1 year return from entry 3 year return from entry
2/26/2001 19 months -11% -8%
10/8/1998 < 1 months 38% 12%
10/17/1990 < 1 months 33% 59%
10/19/1987 2 months 3% 13%
3/1/1982 5 months 34% 63%
3/6/1978 < 1 months 13% 49%
12/10/1973 10 months -32% 9%
1/26/1970 4 months 10% 35%
10/3/1966 < 1 months 28% 24%
5/28/1962 1 month 20% 51%
Average 4 months 14% 31%

Data source: Moneycentral.com

Now that we are in a bear market, shall we move to cash?

I don’t recommend it. Here’s why. From the day the S&P 500 entered a bear market, on average it returned 14% in one year and 31% in three years.

Let’s look at the distribution of returns. This is important. Among the ten one-year returns, two were negative, yet three were over 30%. As for the three-year returns, only one was negative but three were over 50%!

I don’t know about you, but I like those odds.

Warren Buffet said: “Price is what you pay and value is what you get.”

Wall Street uses the price-to-earning ratio, or the P/E ratio in short, to determine whether one gets what one pays for when buying a stock. Is this ratio just a myth? Or is it a useful valuation measure?

To answer this question, I examined the whole stock market data for the past 50 years from 1958 to 2007. For each year, I separated stocks into three portfolios: the top 30% P/E portfolio, the middle 40% P/E portfolio and the bottom 30% P/E portfolio. (Stocks with negative earnings are all in the top 30% P/E portfolio.)

If I had invested $1 in each of the three portfolios at the beginning of 1958, by the end of 2007, the top 30% P/E portfolio would have grown to $91; the middle 40% P/E portfolio would have grown to $322 and the bottom 30% P/E portfolio would have grown to $1698! (The chart below shows the growth of $1 in the three different portfolios in logarithmic scale.)

PE ratio and stock returns

In fact, in the past 5 decades, there was not a single decade in which the bottom 30% P/E portfolio did not outperformed the top 30% P/E portfolio. The decade spanning 1968 to 1977 was especially eventful: two global recessions, the Arab-Israeli war and the Arab oil embargo. The returns of the three portfolios in that decade are as follows:

Top 30% P/E portfolio: 31%

Middle 40% P/E portfolio: 61%

Bottom 30% P/E portfolio: 137%

It is safe to conclude that the P/E ratio is a very useful valuation measure for long-term stock investment. The lower the P/E ratio, the higher is the expected long-term return. That does not mean that low P/E stocks outperform every year though. In the last 50 years, there are 12 years in which the top 30% P/E portfolio outperformed the bottom 30% P/E portfolio. Take 2007 for example, the top 30% P/E portfolio outperformed the bottom 30% portfolio by more than 13%.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

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