Are We At The Point of Capitulation?

Students of the stock market know that market rallies typically begin when price-to-earnings (P/E) ratios are below 15. This ratio really answers the question, "How much are you willing to pay for each dollar of company earnings?" Generally, those rallies begin to fade when P/Es begin hitting the mid to high twenties. The ensuing decline is never pretty, it's never well organized, it typically overshoots to the downside, and it often begins because of some bubble or perceived crisis. After all, high P/Es really indicate optimal conditions. In fact, it may be more appropriate to say that markets with high P/E ratios are priced for perfection. Some shock to the system (and it doesn't have to be a big one) is enough to send people and institutions running for the hills, selling their investments and sending the markets into a tailspin. From this perspective it is easy to see that the S&P 500, with a reported P/E of 24, reflects a market priced for perfection and not tolerant of any "problems".

An oft overlooked ratio is the price-to-sales (P/S) ratio. Similar to the P/E, the P/S answers the question, "How much are you willing to pay for each dollar of sales?" Numbers below one are ideal. Again, referring to the S&P 500, I'm seeing a P/S of 1.2. Not what I would consider a value priced market.

A great index for clues about the future direction of the market indices is the Volatility (VIX) Index. Currently at 36, it has topped out in the low 40s in 2001 and 2002 and bottomed out around 10 in 2005 and again in 2006/2007. The markets have a saying about this, "When the VIX is high it's time to buy. When the VIX is low, it's time to go!" Since February 2007 the VIX has begun a slow, steady climb from 10 to the aforementioned 36. During the same period, the S&P 500 has performed in lackluster fashion.

So how can the P/E, P/S and VIX help us decipher these whirlwind markets?

First off, if your only investment option is a fund, get out and stay out. Move your money into an interest bearing money market account and sit tight. In fact, someone asked me for that very advice today. They said, "Look, should I put my money in a money market account or move it to the bond fund?" Without hesitation I said, "Move it to the money market fund and take the steady interest for the time being." The fact is, interest rates are low. For companies to raise their earnings they need to increase sales relative to expenses and/or raise prices. We've already seen some evidence of rising prices and if the solution includes raising prices even further, you may see higher inflation which will trickle down to higher interest rates. If that does happen the bond fund will produce a loss too. This is the time to move to safe ground and wait for the dust to settle.

Stocks are a different story. This market, raging with disgust, is a stock pickers market. This isn't about short term trading. I'm talking about the long term investor. This is the time to be looking for quality, low P/E, low P/S stocks. For instance, last week I bought shares of a paint company with those characteristics and solid financials. My logic here was quite simple: if you have to sell your home in the current housing market, you definitely need to dress it up to make it stand out. If staying put is your best bet, you'll probably do things to make your space a little more comfortable. In either case, paint is a relatively inexpensive solution.

Are we at the point of capitulation? Well, I think we're close but not there just yet. The P/E must move lower and there are only three ways that this can happen: lower stock prices, increased company earnings or, a combination of the two. With a slower economy increased earnings are unlikely at the moment. That leaves lower stock prices. For the indexes, I'll be a real believer when P/Es get back to a point below 15. As for individual stocks, right now there are great opportunities out there with more to follow. The keys here are research and patience.