Dividend Money

Why Don’t We Buy Stocks When They Are On Sale?

As I came into the office today, I was reminded of what time of year it is. Every year a very large tree is set up and decorated in the lobby of the building. Years ago it was a Christmas tree but as times changed it became known as a holiday tree. This year, in order to spare the slaughter of an innocent tree, it’s a 10 foot steel cone covered in green, prickly plastic. So, as I walked past the holiday cone I was reminded about what’s coming later this week in the U.S. – Black Friday.  

Black Friday

Black Friday is so named because it’s the day that retailers finally move into “the black” for the year and it’s the day that marks the unofficial beginning of Holiday shopping. It’s also the busiest day of the year for most retailers in the U.S. and a day that many items go on sale as businesses compete for those gift shopping dollars. Seasoned shoppers will do their research by scouring through local papers then line-up early in order to get the best deals – after all, if you can get the same item at a lower price, why wouldn’t you?

Strangely, when it comes to investing it seems that people want to pay more. Mutual fund sales show this time and time again. When markets are close to their peaks, mutual fund sales are strong, but when markets are close to their bottoms, mutual fund sales are weak. But who can blame investors? If we look at markets in the U.S., the S&P 500 Index is currently at levels similar to 10 years ago and while Canadian markets have faired somewhat better, it’s still been an ugly 10 years.

A Lesson In History

In 1974 the S&P 500 Index dropped from a closing value of 99.74 on March 13 down to a closing value of 62.28 on October 3 losing over 37% of its value (note that the index is based on price only and does not include dividends). And much like today, there were several events that were weighing on the minds of investors, such as:

1. The energy crisis following the OPEC oil embargo
2. The resignation of President Richard Nixon following the Watergate scandal
3. The loss of Vietnam war
4. An economy in recession

What investor would want to be in the market at a time like that?

Well, as it turns out, a very astute one. The table below shows the returns of the S&P 500 Index following October 1, 1974.

S&P 500 Index

The most important thing an investor can do right now is to learn from history. Although there are some differences between any two periods of time, there are examples of times in the past with many similarities to what we are seeing today.

Those past times represented outstanding investment opportunities in equity markets. No one knows exactly when the market will be at its bottom, but if you’re buying right now, you know for fact that it’s not at its peak. And, like many consumer goods, the market is on sale.

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Using Historical Averages Can Make You Money In Stocks

A concept that I’ve explored lately in this recent volatile market is reversion to the mean, which suggests that prices have a tendency of eventually moving back towards their long-term historic averages.

A good example of this could be the price of oil. After rising 47% in the first half 2008 and hitting a record high of $147 per barrel on July 11, the price of oil has dropped more than 20% in less than eight weeks as supply-demand dynamics adjusted (Not including the speculative bounce last week). Albeit $120 oil can still be considered high by historical standards, the point is that dramatic increases over short periods of time represent imbalances that are likely to self-correct.

Using The Reversion Theory In Your Portfolio

Within the context of recent history, many people might associate reversion with a downward movement so the first thing that comes to mind is something that’s overpriced. However, if we turn this concept over in order to highlight value as well. For example, while oil has soared to new heights, at the other end of the spectrum global equities have been punished and U.S. stocks in particular have struggled amid the credit crunch and a deteriorating economic backdrop.

Over the last 12 months, the return on the S&P 500 Index has been about -11%. Consider however that the average annual return on U.S equities over the past 25 years is 11.4%. On this basis, investors (especially those sitting on the sidelines in cash) might want to ask themselves whether they think stock prices in the world’s largest and most diverse economy will stay at current levels indefinitely, or whether it’s more reasonable to think that at some point, they’ll revert to more historically normal levels.

Analysts spend many hours and a boat-load of money determining what they perceive as fair value for equity markets. Their valuation models incorporate long run averages for inflation, interest rates and growth and based on current levels for these factors, U.S. equities appear to be trading below fair value. Another way to interpret the reversion theory essentially is a version of the “stocks on sale” message.

Reverting To Positive Returns

If U.S. equities are trading below where they should be based on historic averages for similar environments, then it follows that at some point, they should move back towards fair value, meaning stock prices should eventually rise.

Now, I am NOT forecasting what the price of oil will be or where U.S. stocks will be trading six months from now or when reversion will happen – I’ll leave that to the “experts” . The message to take from this is that amid 200 point swings in the stock market or $10 spikes in oil prices, it’s prudent to think about where prices are in relation to historic long run averages.

In a volatile market it becomes very difficult to predict which individual stocks are going to be most successful. However, buying a broad index such as the S&P 500 will offer significant exposure to a US equity market that has become oversold and is valued at well below historical averages. Not to mention that the S&P 500 has a dividend growth rate of about 11%. So, buying this index offers you an average of 11% raise each year while we wait for valuations to return to the mean.

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