For many who are against actively managed funds, index funds are the only game in town. Index funds have the advantage of having lower fees than active funds and have also proved to provide investors with higher returns than 95% of actively managed funds over the long-term.
With index fund investing, you simply buy into an index such as the FTSE 100 or the S&P500 and hold it for the long term whilst obtaining passive income from it. Whilst index funds offer more attractive net returns to investors, it is important to buy these indexes at the right time in order to maximise returns. Whilst ‘perfect’ market timing is impossible i.e. selling right at the top of the market and buying at the bottom, you are certainly able to buy or sell the market at about the right time using the right tools. Just like you would buy (or sell) an individual stock if its valuations are too low (or high), you can use this same method to attempt to buy into the market if the valuations sound appealing. Here we look at 4 simple ways anybody can use to value the stock market.
1. P/E ratio (Price Earnings Ratio)
The P/E ratio is what most value or Warren Buffet style investors use gauge whether or not it is a good time to buy a certain stock.
To calculate a company’s P/E ratio, you simply divide its share price by its earnings per share.
If ABC plc has a share price of £20 and earnings per share of 100p.
The P/E ratio is £20/100p = 20
A P/E ratio of 20 means that for every £20 I spend buying company ABC plc stock, I should receive £1 of profits a year later.
Now whilst P/E ratios are normally used to value a stock in a company, it can also be used to value the market as a whole. To calculate the P/E ratio for a stock market or index, you divide the total market value of all of the market’s constituents by their combined earnings.
Once you obtain, the P/E ratio of a particular index or stock market, you would compare the figure against the historical norm. Different indexes have different historical averages. The FTSE 100 has a historical P/E average of 14 whilst the S&P 500 has an average of about 15.5.
Right now the FTSE has a P/E of 16 whilst the S&P500 has a P/E closer to 21. This jut shows you that the S&P500 is overvalued and a correction may be coming soon. (A good place to look at P/E ratios is at http://www.multpl.com/).
2. Market Cap to GDP Ratio
Whilst Warren buffet loves the P/e ratio for individual stocks, his proffered method for the entire market is the Market Cap to GDP ratio. He states that this ratio is the “single best measurement of market valuation at any given time.”
When the total market cap as a percentage of GDP is greater than 90%, stocks are generally overvalued. When the ratio is below 50% stocks are incredibly cheap. When the ratio is above 115%, stocks are getting frothy.
Here is a good place to get the data on Market Cap to GDP Ratio “http://www.vectorgrader.com/indicators/market-cap-gdp”.
3. Earnings Yield
The yield is the earnings for the market for the most recent 12-month period divided by the market capitalization. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the market.
The earnings yield tells us how much our current investment monies are buying in terms of company earnings. When the yield is high (above 6-7%), we’re getting more bang for our buck.
4. 10-Year U.S. Treasury Yields
The 10-year U.S. Treasury bond is considered to be a “risk free” investment asset. If you can get a “risk free” return of 5% by investing in 10-year U.S. government bonds, wouldn’t you be less likely to invest in ‘risky’ stocks?
When U.S. Treasury bonds are cheap (yielding more than 4.5%), less people are willing to buy stocks.
By knowing these 4 metrics, you can quickly place value on individual stocks or the market as a whole.
When the market is overvalued by these metrics, start paring back on your allocation to stocks. When the market is undervalued, invest your money wisely by buying more more stocks. Read this article to see exactly which market are undervalued at the moment “http://moneygrower.co.uk/2015/03/the-4-stages-of-a-stock-market-and-where-we-are-now/”