Phil: What Should Rule #1 Investors Do in Today's Market?

[Patrick]

From Phil's Blog

August 20, 2008

What Should Rule #1 Investors Do in Today's Market?

Last week I received a comment on the blog, from reader Andrew:

Phil,

You said you would let us know when it was time. Well the P/E ratio of the S&P 500 with 2Q data is showing that its rising? I'm assuming companies are becoming more over valued because price is going down but earnings are dropping even more. Can you help explain? Ready to rock.

Here's what I told him:

Cash is still king. This market is very likely to continue its long ride to nowhere. I'm not a fan of market prognostication, but that said, we have had a market PE above the average of 16 now since 1990 and we haven't seen a real deep discount of the S&P 500 PE ratio since 1983. If interest rates start to ratchet up to counter inflation, that's probably when we'll see PE ratios drop. And that's when we load up the truck.

Here's why:

The average rate of return on the whole market following a market PE of 9 has been 16% per year for two years. Of course, if you buy particular businesses in a market downturn, you can do even better.

Between 2000 and 2003, business income dropped in half and so did the market... but the market had been so overpriced in 1999 that the PEs stayed above 16 in spite of the loss of earnings.

So was the market overvalued in 2003 when the Dow was at 7500? Buffett certainly thought so and was not, therefore, an aggressive buyer. He went shopping elsewhere - overseas for the Euro and in China for oil and in the US for private businesses.

In general Rule #1 investors do not buy a business unless they are certain it is a great deal. We can trade stuff using the arrows, but to really dive in there and own the thing takes a really great price and we just haven't seen many... But they are coming soon.

Buffett said in May that he hoped that all of his stocks would drop 50% soon... so he could buy more. We should be hoping for the same thing, but instead of sitting there while they go down, we should be selling them off using the tools I taught you.

Be patient, trade, be light and nimble. Load up your cash. It's going to get nasty out there and I want you to be ready.

Now go play.

Phil