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A Common Sense View for Investing in Stocks

Chad Karnes

Henry David Thoreau is credited as saying, "Things do not change; we change". This is especially important when trying to take an objective look at the financial markets. Recognizing that the markets and financial analysis don't necessarily change, but our justifications and rationales can and do, is a big step in the right direction of objective analysis.

The last few weeks I have examined the markets using our four pronged approach to help facilitate an unbiased perspective. Fundamentals, technicals, and sentiment are all important, but sometimes a little common sense goes a long way.

A Little Common Sense Thomas Paine, in his famous book Common Sense wrote, "A long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason." Today, we have a simpler term for this type of thinking, recency bias.

The market (QQQ - News) has now rallied for four years. Following Paine's script, if we were to ignore any history, then investing now might make sense as the market's four year rally has indeed created a superficial appearance that buying into this rally works. The "Fear of Missing Out" as we discussed in our most recent Newsletter speaks to just that.

But we as well Thomas Paine know that just because something is in place for awhile doesn't necessarily make it right or certain it will continue into the future, and that is all you should care about if you are putting new money to work today.

Wall Street in its usual role is the formidable outcry in justifying a rising market begets a rising market (VTI - News), but the tumult may soon subside, just as it did in 2000 and again in 2007.

Based on a longer history of a simple chart of the stock market, does this look like the appropriate time to put new long term money to work?

Time Creates more Converts than Reason

The average length of a cyclical bull market within a secular bear market lasts 3.1 years. We are 4.2 years into this rally, well past that 100 year average before a sizable pullback.

The chart below, included in our April ETF Profit Strategy Newsletter, shows that statistically this market (SSO - News) has rallied longer than most of its previous post recession rallies and is the third longest ever. After each of the rallies listed below followed a deep correction (UVXY - News) that presented a much better longer term buying opportunity as P/E's moved back below historical averages, and investors got more for their money.

Common Sense Valuation Prices (SPY - News) have risen over 140% the last four years and valuations are now showing it.

Valuations suggest that companies are relatively expensive as the 10 year Shiller P/E resides at 24x. This compares to a 130 year average of 16.5x and a median of 15.9x. As we suggested in our latest Newsletter release 5/23, "By this measure stocks are hardly a screaming deal. U.S. stock prices at this precise moment should be purely viewed as a momentum play with expired plates".

Using simpler P/E ratios, the latest quarter's reported earnings of $88 came in at 18.6x, from a low of 13.0x just 18 months ago when earnings were just $1 lower at $87. This shows that investors are paying much more today for essentially the same amount of earnings (chasing prices instead of earnings).

A final look at the inflation adjusted S&P earnings shows that they actually peaked at $95 in June of 2007. This means that investors are still paying more today for real earnings of $88 than they did in 2007. The real P/E today of 18.2x compares to 2007's market peak P/E of 16.5x.

Today's market prices are higher than they were at the 2007 market peak (SSO - News) given earnings levels and are also higher than the historical average and median by pretty much all measurements.

Combining our Four Pronged Approach Taking a step back and recognizing that most markets (IWM - News) have rallied over four years and are up significantly, making companies much more expensive today than they were even 18 months ago, is a good start in developing an unbiased long-term opinion using some common sense.

The fundamentals, as outlined in my recent article "Earnings Games", suggest that the market indeed has gotten ahead of itself as earnings growth slows to a halt.

However, the technicals, which I also recently discussed on ETFguide.com, have yet to confirm a breakdown in the uptrend, and 1600 is the first price level to watch for that trend change.

As outlined in our Technical Forecast, "thus far 1600 has held, but if it fails, then it is likely the larger trend has turned down". Until 1600 fails, the trend remains up, but all the other warning signs are there and suggest that when the trend does finally break, the expected pullback, just as history teaches us, could be sizable, but normal.

Just because the markets have rallied and are up doesn't mean we should give into our fear of missing out and make a long term decision that is not currently ideal. Remember, "A long habit of not thinking a thing wrong, gives it a superficial appearance of being right". Or, as we like to put it, "the market may have legs, but it has no brains".

The ETF Profit Strategy Newsletter uses independent and unbiased common sense in analyzing the fundamentals, technicals, and sentiment to stay ahead of the markets.

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