2 Charts Tell You Which Stocks to Buy … and When to Buy Them
Last week, I shared some bad news about the outlook for the traditional 60/40 portfolio.
The popular retirement allocation is facing the biggest drag on returns than at any time in at least two decades.
And it’s not just because bonds can’t deliver yield. U.S. large-cap stock returns are expected to fall over 6% every year for the next seven years, according to leading investment firm GMO.
There’s no shortage of yardsticks to measure stock prices relative to fundamentals. And they pretty much all show the same thing … stocks are expensive!
This week, Ted explained one measure favored by Warren Buffett. Another popular gauge is the cyclically-adjusted price-to-earnings (CAPE) ratio.
Although a mouthful, this indicator is actually quite simple. It compares the price of a stock or index to an average of earnings over time, usually the last 5 to 10 years.
By averaging earnings, it helps smooth out the ups and downs of the business cycle and the impact that can have on profits.
Here’s the CAPE ratio for the U.S. over time:
Based on this measure, stocks have only been more expensive once … during the 1990s dot-com bubble.
And if you bought the SPDR® S&P 500 ETF Trust (NYSE: SPY) the last time stocks were this expensive, you went on to experience a 30% decline. It took more than three years for this exchange-traded fund (ETF) just to reach breakeven.
But, as Ted wrote yesterday, while stocks are expensive domestically, they’re cheap in many international markets.
In fact, while the CAPE ratio for U.S. stocks is 32, the measure for emerging markets is less than half that figure at 15.
Developed European markets come in at 17.
That means great long-term opportunities in international stocks.
But there’s one question CAPE can’t answer … when is the time to strike? To identify the right investments, at the right time, there’s one more tool you need in your toolkit.
This Indicator Is Flashing BUY
Studies have proven that the CAPE ratio does a tremendous job predicting returns on a longer-term horizon … think at least 10 years and beyond. But it doesn’t reveal when prices will actually start to reflect valuation realities.
That’s why I combine that fundamental analysis with technical analysis. The fundamentals tell me what, while the technicals tell me when.
And there’s one measure that can help you overcome the challenges posed by timing: relative strength analysis.
If you simply chase the lowest CAPE ratio, you risk catching a falling knife. It could be cheap for a reason.
Instead, you should demand proof that things are improving with the opportunity you’ve got your eyes on.
Let me give you an example of how to do that. The emerging Asia-Pacific region has a CAPE ratio of 16.7, and one ETF that tracks the region has seen a recent surge in momentum … it’s nearly doubled the gains seen in the S&P 500 Index year to date.
And that has set the stage for a breakout to new all-time highs. See for yourself:
While astronomical U.S. stock valuations could mean declines ahead, there are plenty of great opportunities in international markets.
Research Analyst, The Bauman Letter