Right now, the stock market has been in an up trend for years and hasn’t suffered a pull back of 5% or more in more than a year. This seems like we could be near a significant top. And, that means now might not be the ideal time to buy new stocks.
Of course, those same words could have been written at any time in the past few months. Not buying may seem like a cautious approach to take to the market, especially when it is going up. But, not buying carries perhaps the biggest risk to small investors.
The arguments against buying have been in place for more than a year. In fact, most of the time, the stock market is overvalued by at least some popular measures. The chart below shows the Shiller Cyclical Adjusted Price to Earnings (CAPE) ratio.
Source: Dr. Robert Shiller
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CAPE is a long term indicator that is designed to smooth out the effects of inflation and the business cycle. It can be considered to be on a buy signal when it is below its 10 year moving average. It indicates stocks are pricey, or overvalued, when the ratio is above its 10 year moving average.
CAPE has been above its 10 year moving average since 2013. Yet, the S&P 500 has gained more than 50% over that time, an average annual gain of more than 12.9% a year when dividends are included.
Not buying over that time carried a high cost. A $1,000 investment in the S&P 500 made when the CAPE ratio first moved about its moving average would be worth more than $1,600 today. That same $1,000 in a savings account would be worth about $1,000.
Maybe, There’s Almost Always a Good Time to Buy
Looking at the cost of not buying stocks, it seems that avoiding the stock market, even when it is overvalued can be a mistake. That means investors should develop a plan for buying and selling. We recently discussed selling disciplines in our blog and urge you to have a plan for selling even before you buy.
In this article we are addressing the idea of buying. For many investors, the idea of what to buy comes down to the decision of whether they are fundamental, technical or discretionary traders.
Fundamental investors use data found on a company’s financial statements. They may want to buy companies with low P/E ratio or strong cash flow. One way to find stocks meeting these requirements is with the free stock screening tool available at FinViz.com.
At this site, you could screen for a variety of fundamental factors, high levels of institutional ownership and bullish institutional transactions. An example is shown below.
This screen could be run any time to obtain a list of buy candidates. Then the question is when to buy? The answer is now. As long as an investor has a disciplined approach, buying can be done anytime. Follow a strong sell discipline and buy undervalued stocks. In the long run, this is a recipe for success.
Technical traders can use charts and indicators to determine when to buy, and when to sell. Fundamental indicators can even consider adding a technical filter to their buy decisions. The chart below shows one such filter.
This is a chart of the SPDR S&P 500 ETF (NYSE: SPY) and its 200 day moving average. The moving average is shown as the solid blue line. As long as prices are above the moving average, we are considered to be in a bull market. This can help all investors decide when to buy.
Combining Technicals With Fundamentals For the Best of Both Worlds
Buys might only be made when the market is above the 200 day moving average. When SPY is below the moving average, no new buys would be made. Sell signals would be followed and cash would build up when the sells are made. New buys could be deferred until SPY is back above its 200 day moving average.
More conservative investors could use a 150 day or a 50 day moving average. Busier investors could use a 10 month moving average and glance at a chart just once a month to make portfolio decisions.
Investors have found success with both fundamental and technical approaches. They simply follow buy rules and sell rules. Discretionary traders can find success but it is a more difficult path to follow.
Discretionary Trading Can Destroy Wealth
A discretionary trader might decide to buy a stock based on discretion, which is often just a large word used to hide the fact the stock is being bought based on a hot tip. Since there is no real reason to buy, there is no real reason to sell based on a hot tip.
Discretionary traders may be successful, and George Soros is one who has made billions trading without a clearly defined and reproducible systemic set of rules. However, it seems safe to say that most of us are not George Soros. We don’t have access to the same information and we cannot process information in the way he does.
Rather than following discretionary ideas to trade, systemic rules could be more hopeful. To decide what to buy, decide whether you will use a fundamental or technical approach. Then, develop rules based on a tool that has worked in the past.
To decide when to buy, again, set rules. You may decide to buy when SPY is above its 200 day moving average. Or, when a stock breaks out of a technical consolidation pattern. Or, when SPY is above its 50 day moving average.
When deciding when to buy, there are dozens of rules that can help you succeed. You must, however, follow the rule with discipline for the long run. You are unlikely to succeed if you change rules often or override rules because of a hot tip or a hunch.
Planning Could Be the Real Key to Success
No matter why you buy or how you buy, have a plan for selling. Decide in advance how to handle winners and losers. And, stick to the rules. Traders often say a long term investment is a short term investment that lost money.
This means the trader bought something expecting a quick gain. But, the price fell. They then decided that it would come back in the long run. Prices then fell more and they now have a large loss. Don’t let this happen to you.
Selling is easier when you have a plan for when to buy the next investment. You might sell a losing position, but SPY is still above its 200 day moving average. This means you would immediately buy something else that meets your buy rules.
We have written about many fundamental screens that could be interesting to you. We have also described technical patterns that could be appealing. If you are new to investing, consider reading through previous blog posts to flesh out a complete set of rules.
You should be able to create a set of rules with a few hours of research. Then, you must follow those rules. If you are concerned that you don’t have the discipline to follow sell rules, consider using a service.
The Trading Tips service, PPK System, is designed to exploit patterns associated with market clues by looking for value and momentum in stocks. That’s the combination many researchers found beats the market. It has strict rules for buying and selling. You can learn more about this trading service by clicking here.