How to Tell if It's a Good Time to Invest

August 24, 2016 |

Before investing or making big changes to your portfolio, it’s worth determining if the present moment is a good one to be making new equity investments, or if it’s better to have a higher allocation of cash, bonds, or other low-volatility instruments. Here we’ve put together a list of resources to help you figure out an answer to that question so that you can allocate your capital judiciously.

Forgive me, but before going on I want to plug our Weekly Market Brief, which is a handy 1-pager highlighting three major economic events or reports from the week. Much of the economic information described in this article gets included in the brief, plus the weekly market moves. The Market Brief is always in Stock Rover’s newsletter, or you can find it every Friday afternoon on our blog.

Ok, let’s get to it. Please note that this article is meant to serve as a reference for the data that you need to tell if it is a good time to invest, so for that reason it includes many links, most of which are rounded up in a list at the bottom of the article.

A Fundamental Question for Investors

Before making any investment decision, any investor should ask this simple question:

Is now a good time to invest?

This raises more questions, like:

  • Is the economy sound?
  • Is the market expensive?
  • What are interest rates doing?

Let’s figure out how you would go about answering these questions. In our next article, we’ll attempt to answer all these questions for the current economic and market environment, but for now, we just want to point you to all the relevant resources.

Is the Economy Sound?

In considering if the economy is sound, let’s start with the basic question of how likely a recession is in the near future. Recessions are very bad for stocks and will destroy a lot of investor capital very quickly. Recession danger is signaled when some or all of these factors appear:

  • The yield curve is inverted (i.e., short term interest rates exceed long term rates)
  • Unemployment claims are rising
  • Personal income is down
  • Consumer confidence is falling
  • Industrial production is declining
  • Inventories are increasing

The Yield Curve

An inverted yield curve is bad because it means that investors and the Federal Reserve are fretting about inflation in the short term, and that investors are pessimistic about long-term growth and expect that the yields offered by long-term fixed income will continue to fall.

Treasury.gov has a yield curve chart as well as a yield rates table. As long as long-term rates exceed short-term rates, then the yield curve is normal and not inverted.

Unemployment Claims

To check on unemployment trends, you can refer to this graph of the unemployment rate. For more detail on claims numbers, the U.S. Bureau of Labor produces a monthly report, found in HTML (kind of an eyesore) or in a friendlier PDF here. You can also see the weekly jobless claims report every Thursday in the Econoday calendar.

Personal Income

The Bureau of Economic Analysis (part of the U.S. Department of Commerce) publishes the Personal Income and Outlays report on a monthly basis. You can pull the most recent report from the list of news releaseshere.

Industrial Production

The Industrial Production and Capacity Utilization report is published monthly by the Federal Reserve Board of Governors. You can see that information here, including how the numbers have changed from month to month.

You should also look at the Gross Domestic Product (GDP) growth rate, which is the standard measure of general economic health. The GDP growth rate in the United States is reported by the U.S. Bureau of Economic Analysis. Find a chart of the quarterly rate here.

Inventories

Inventories provide insight into production activity in the near term. If inventories are increasing, it suggests there will be a slowing of production activity while the existing inventories are worked down. Trading Economics charts the change in inventories from quarter to quarter. For a chart of inventories/sales ratio, see the PDF published here on the U.S. Census Bureau’s site. A lower ratio is a positive signal for near-term production activity.

All of the above information will help you understand recession risk. If a recession seems highly possible, you may take a more conservative approach to your investing, leaving much of your capital in cash or in safer instruments than stocks. If most of the above indicators are not suggestive of a recession, then continue with your assessment of the macro environment.

Is the Market Expensive?

Just like individual stocks can be expensive, the entire market can go through periods of being expensive (or cheap). Value investors are already highly attuned to this type of information, but even if you’re not a dyed-in-the-wool value investor, it’s still very useful to get this context before looking at individual stock pricing.

Whether the market is expensive is commonly determined by looking at the P/E of the S&P 500 relative to historical norms. Note that the S&P 500 is large cap, and getting context on mid cap and small cap pricing is a little more challenging because the historical data is not as easy to find. However, you can use ETF proxies of small and mid cap indices, and compare their P/Es to that of the S&P 500. For example, you could use IJHfor the S&P Mid Cap 400 or SLY for the S&P 600 Small Cap. In general, you would find the mid and small cap multiples to be in the same neighborhood as the S&P 500’s, although probably a touch higher, because the growth expectations for smaller companies are usually higher.

S&P 500 Historical P/E Ratio

Let’s start with the S&P 500 as it is the most commonly looked at indicator for determining the valuation of the market. Thanks to multpl.com, it’s a snap to see what the average P/E of the S&P 500 is and has been in the past. See the graph here.

Note that the reason the S&P P/E was so high in 2008 was because the “E” portions of the equation (earnings), plunged dramatically, which can be seen in this raw data table from NYU Stern Business School.

Historical Shiller P/E Ratio

For another angle on the market’s valuation you can look at the Shiller P/E, or CAPE ratio. Robert Shiller is a Yale University professor who helped create the CAPE ratio (cyclically adjusted price-earnings), also known as the Shiller P/E ratio. Here is how he describes it:

“Using inflation-adjusted figures, we divide stock prices by corporate earnings averaged over the preceding 10 years. Our ratio differs from a conventional price-to-earnings ratio in that it uses 10 years, rather than one year, in the denominator. It does so to help minimize effects of business-cycle fluctuations, and it’s helpful in comparing valuations over long horizons.” (from the NY Times)

See the graph of the Shiller P/E over time here.

Note that one of the reasons the CAPE has been so high is the last 10 years includes the exceptionally poor years of 2007 and 2008 (2006 and 2009 weren’t so hot either). So four of the last ten years were significantly below trendline earnings wise. Depending on how much of an anomaly you view those periods, will probably shape your views towards the value of this measure.

S&P 500 Historical P/B and P/S Ratios

You can also quick review other measures of the S&P 500 valuation to see if they complicate the picture, or if they support the story told by P/E. Also at multpl.com see graphs of the price/book (P/B) and price/sales (P/S) ratios for the S&P 500 over time.

Risk Premium of Equities

The risk premium of equities is the earnings yield of equities minus the “risk-free” treasury yield (earnings yield is in the inverse of P/E; note there are other ways to calculate the risk premium, but I like the simplicity of this approach). This gives you a sense of roughly how much of a yield benefit you should expect for the risk you take on when you invest in stocks. This concept should be used broadly, as yet another piece of information to help you understand the market context, and not as the basis for any strict make-or-break rules.

When the market is expensive, the earnings yield is lower and therefore the risk premium goes down. If the risk premium is low, equity investing becomes a less attractive option. However, when the treasury yield is low (see this graph of the 10-year treasury yield over time), as it is at the time of writing, this means the risk premium can still be decent, even when stocks are expensive.

What Are Interest Rates Doing?

Interest rates act on financial valuations the way gravity acts on matter: the higher the rate, the greater the downward pull. — Warren Buffett

It’s useful to know where interest rates stand and whether they are expected to change in the near future, so that you can make better predictions about how your investments could be affected.

First, where to get the information. The Federal Open Market Committee (FOMC) which sets the federal funds rate meets 8 times a year and releases its meeting minutes with a 3-week lag. Monetary policy is of great interest to economists and investors, so news about it and its implications are not hard to find. To get the information straight from the horse’s mouth, you can find the FOMC calendar, statements, and minutes all on this one handy page from the Federal Reserve Board of Governors.

Next, what to do with the information. This is trickier because, as you’ll see, monetary policy has a wide range of implications.

Since the Great Recession, interest rates have been exceptionally low in order to create a low-friction environment for economic recovery. The economy has slowly been healing, but interest rates remain very low. The FOMC is keeping a close watch on inflation so that they can raise the rate when the economic growth feels stable enough.

If interest rates stay low, this can indicate a weak economic recovery and a low growth environment that isn’t ideal for equity investing. On the other hand, if interest rates rise, it indicates economic recovery and growth, which is good. But the worry is rising rates may mean inflation is on the horizon, and higher rates will slow growth, increase the cost of debt to corporations and make stocks less attractive, especially relative to bonds, which will be issued with higher coupon rates. If you want to spend a little more time with these concepts, we have a primer on the effects of a rising interest rate (in response to when the Fed raised the rate by 25 basis points in December 2015).

So the stock market always has worry. Worry is a good thing, it keeps the market in balance and can dampen excess.

A look at history tells us that the occasional, gradual rate increase is nothing to fear. While there is likely to be turbulence after any rate hike, markets should fare okay for quite a while. However, if an interest rate rise is sustained and prolonged, then look out. Lower returns and higher inflation will make stock market investing a much less appealing choice.

What Sectors Work in a Rising Rate Environment

Rising rates generally mean a strengthening economy. Sectors that especially benefit are financial services, consumer cyclical (AKA discretionary), and industrials. Financial services benefits from margin expansion (their spread is bigger) and fewer non-performing assets. Consumer cyclical and industrials benefit from increased consumer demand. Technology can also benefit as well. You can find a deeper discussion of this on Investopedia.

Cycles

Finally, another thing to consider is the cyclical nature of the market. Let’s take a look at two cycles that might affect your investment timing.

The Presidential Cycle

A study done at Pepperdine University in 2012 concluded that there is a propensity for the DJIA to rise during the second half of the four-year presidential cycle. The authors believe this pattern has repeated since 1950.

The cycle begins on October 1 of the second year of the presidential term through December 31 of the fourth year—this is called the favorable period. Historically, this period performed much better than the unfavorable period, from January 1 in the first year of the presidential term through September 30 of the second year.

Since news about any presidential election is all but inescapable, you should have no trouble figuring out where in the cycle we are. It is August 2016 at the time of writing, which means we are in the last few months of the favorable period.

Sell In May and Go Away

The old saw “Sell in May and Go Away” is meant to capture the essence of a cycle where stocks perform much better in the period between November 1 and May 1 than they do between May 1 and November 1. There is historical truth to this cycle. I did an analysis of it a few years ago, looking at the SPY, which is an ETF proxy for the S&P 500 between the years 2000 and 2013 and found the following:
may novemeber

Note that for the S&P 500, the May-November gain was 0.9% whereas the November-May gain was 4.0%. Sector-wise energy (XLE), health (XLV), discretionary (XLY) and financials (XLF) showed the biggest period differences. Consumer defensive (XLP) and technology (XLK) actually did better in the May-November periods.

Links Roundup

Here is a short list of the links where you can get up-to-date data.

Yield Curve or Yield Table

Unemployment Rate Chart or Unemployment Report Details

Econoday Economic Calendar

Personal Income and Outlays Releases

Consumer Confidence Index

Industrial Production

GDP Growth Rate

Historical Valuation of the S&P 500 (go to “See Also” at the bottom of the page for additional metrics)

10-Year Treasury Rate

FOMC Schedule and Meeting Minutes

Rover’s Weekly Market Brief

Summary

Now you know how to assemble a macro picture of the investment environment. How you choose to navigate the environment is completely up to you, based on your goals, your timeframes, your tolerance for risk, et cetera. That said, here are a few concrete tips that the average individual investor might want to heed:

  • If the recession risk looks high, allocate more of your capital to cash and bonds or low-volatility instruments.
  • If the risk premium of equities is high, allocate more toward stocks.
  • In a rising interest rate environment, consider allocating more toward the financial, consumer cyclical, industrials, or technology sectors.

Next week, we ll practice this by running through all the sources covered above to see what we can learn about the current investment environment.





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