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3 Sure and Simple Indicators for Stock Market Success

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Up until the mid-1980’s, canaries were used as an early warning system in coal mines. The birds’ high metabolism and rapid breathing rate, on top of their small size, meant they would concentrate atmospheric toxins in their bodies quickly. Deadly underground gases such as methane and carbon monoxide would affect the birds before reaching concentrations that threatened human miners. Warned that conditions were unsafe, miners had time to don respirators and escape unharmed….

Like the canary in the coal mine (which mercifully has been replaced by technology), there are certain stock market indicators that have proven to give us an early warning of the health of our stock, mutual fund, and ETF holdings.

The truism that you "can’t predict future stock movements" is really only half true. In fact, it is extremely difficult to predict the exact moment of most stock market moves. Only a small percent of investment managers are able to time the market in any given period. And, over decade-long time spans, essentially all of them lose that special touch.

But there are a few simple indicators that do tell you, with a reasonable degree of assurance, the probable long-term direction of your holdings. Let’s take a closer look at price-earnings ratios, expenses, and yield….

Price-Earnings

The price-earnings ratio (P/E or "multiple" for short) is a measure of stock value computed by dividing a company’s share price by its annual earnings per share. (Usually earnings for the past four quarters, but sometimes going farther back, and sometimes estimated future earnings.)

Why is P/E a sure and simple indicator for success? It’s no more complicated than this: when you buy something at a sale price, you’re likely to get a better value.

John Campbell and Robert Shiller found that P/E 10, price divided by average real earnings for the previous 10 years, is especially useful in forecasting future stock price changes. Their findings fit our intuitive notion of "mean reversion." Generally speaking, any series of measured values (whether stock prices or sports statistics) will return to their average, over time. No winning streak lasts forever. So when the market is at a high or low, it will most likely return to its average performance.

Other than at a few historical extremes, the P/E for the S&P 500 has ranged between about 10 and 20 most of the time, with an average of about 15. Today it’s around 16, meaning it’s somewhat harder to find bargains.

The price-earnings ratio is most useful for comparison shopping. If you have two investment choices that are otherwise equal, the P/E will often indicate which is the better "value." Buy at low P/E’s and odds are better that your holdings will rise over time.

Expenses

The next sure and simple indicator is investment expenses. Future investment returns may be unpredictable, but investment expenses are a known drag on your portfolio, year after year.

With mutual funds, excessive expenses tend to indicate trading or active management, which, on average, lags the market. Not only are higher management expenses not matched by better performance, as a rule, but they are actually a negative for performance. That high-priced fund manager usually doesn’t earn his pay, and the steady charges against your portfolio damage it over time.

According to Burton G. Malkiel, Professor of Economics at Princeton University, "…well over three quarters of the typical actively managed equity funds underperform the S&P 500 stock market." Recent research by Morningstar found that the expense ratio is one of the best measures available to filter for relative performance. The lowest cost equity funds had a return advantage of 1.77% a year over the highest cost funds! Over time that’s an insurmountable advantage. Simply put: the lower your expenses, the higher your returns.

What should expenses be? Even in my portfolio, which has some legacy positions from the days before ETFs and passive investing were common, my average expense ratio is less than 0.30% per year.

If you are building a portfolio from scratch using modern, inexpensive ETFs, you should aim for an overall expense ratio of just 0.10% to 0.20%. For a hypothetical $100,000 portfolio, that’s a razor-thin $100-$200/year, in expenses, versus a potential $1,000-$2,000/year hit for typical actively managed funds.

That is a critical difference, and a large sum of money when compounded over time. Saving $2,000/year in expenses over the course of a 30-year career where you earn an 8% investing return amounts to over $225,000 in additional savings!

Yield

The last metric of interest to anyone wanting a sure and simple approach to investing is dividend yield. That is the regular income you can expect from your holdings, month after month, or quarter after quarter, despite any gain or loss in prices.

Over the long haul, companies that raise their dividends regularly — increase the yield on their stock — are the most valuable. For example, the S&P 500 Dividend Aristocrats Index has outperformed the broader S&P 500 by more than 2% annually over the last 20 years. Perhaps more importantly, those dividend-payers have done so with less volatility, especially in falling markets.

Generally, companies that can pay steadily increasing dividends have stable businesses that perform well in all economic seasons. In times of increased volatility and reduced expectations for growth, recurring income from your investments is not only reassuring, but may be critical to achieving any return on your money.

There are some indications that the world may be undergoing a sea change where high rates of economic growth are no longer possible due to resource constraints. In such a world, price appreciation may never happen, and predictable income from your investments may be the only return you can count on.

What’s a reasonable yield? It all depends on current economic conditions. In 2008 the Federal Reserve began historic measures to depress interest rates and stimulate growth, making it extremely difficult to achieve yields anywhere near historical averages. You should generally aim to achieve a yield several points above the current rate of inflation, without taking on unwarranted risk in your investments.

A Bird in the Hand…

Success in the stock market is much more certain if you can slowly and steadily head in the right direction for the long haul. But there are many fatal attractions along the way.

Greed leads the list. Many investors and some money managers succumb to the temptation of the quick win or the big kill. Occasionally they get lucky. But most often they don’t.

A bird in the hand — cheap initial prices (P/E), low ongoing costs (expenses), and regular income (yield) — is worth far more than those proverbial and elusive birds in the bush.

So, as you mine for gold, don’t pass up a sure thing for an uncertain possibility that could leave you empty-handed. Invest for the long term, while minding these three indicators. They’ll provide fair warning, and higher odds for success.

Comments

  1. Nice post. I've been making my way through your entire blog – good stuff. Thanks for the link to the PE ratio. Is there a similar indicator for bonds?

  2. Darrow Kirkpatrick says:

    Thanks prob8, I appreciate the feedback. There isn't a universally accepted indicator for the relative value of bonds, analogous to P/E, that comes to my mind right now. Though, for bonds of the same credit quality, you could simply compare yields and generally assume the higher yield is the "better" value.

  3. Thanks for the response. I didn't think there was such a thing but I thought I would inquire since you've obviously spent some time researching. My problem is that I know I need more bonds in my portfolio. I have 7% in bonds now (all of which is in VBILX). Despite knowing I need more bonds, putting cash in is tough given where interest rates are, where they are likely to go, and bonds seem to be at a peak as far as price is concerned. Did you face this sort of scenario during your wealth accumulation phase? If so, how did you proceed?

  4. Darrow Kirkpatrick says:

    My approach, when you know you need to be better diversified, is to get better diversified, even if it might be expensive. Because the downside of not being diversified is potentially worse. That said, I never made any large moves quickly. It's always been a gradual process, generally not touching more than 5% of my portfolio at a time. You probably know that by sticking with short and intermediate-term bonds, the damage from a rise in interest rates will be muted. And we all "know" that interest rates must rise, but we've known that for years now, and there is no telling when.

    Truthfully, I did not face this historically extreme scenario during most of my accumulation phase. It was usually clear that bonds or stocks where undervalued, and I would just dollar-cost-average into which ever seemed the better bargain. Accumulation is easier, because you are making a decision every month — the potential for a major mistake is lessened. On the other hand, waking up and deciding you need a major rebalancing is riskier. If it were me, I'd make a plan, but implement it slowly, over time.