At dinner parties, coffee shops, classrooms and churches, the common voice of America is focused on the same two topics: recession & unemployment.
I have personally never seen a collective outlook so hopeless and dejected, where being positive about anything is seen as foolish. In short, the opportunity to invest in stocks continues to be wonderful.
I have written ad nauseum about the fact that times of great pessimism are the best times to buy stocks. But, since people find this so counter intuitive, here is the reason expressed in simple numbers…
Stock prices are determined by two major factors – company earnings and popularity. Times of pessimism tend to follow some great crisis that hurts company earnings and creates walls of worry.
Worry causes people to pay less for what earnings companies have, as reflected in a low price-to-earnings (P/E) ratio. During times of prosperity, the average P/E ratio of the market might be over 20. During times of deep pessimism, the average P/E of the market might be in the single digits. For the patient investor, the effects of company earnings and market P/E over the course of the business cycle is profound.
Say, for example, that during a recession, manufacturer General Electric's earnings are $1.00 per share at a P/E of 15, giving it a stock price of $15.00. After a few years, as the economy improves, GE’s income returns to $2.00 per share (the same level as before the recession, assuming that the company doesn't grow at all). At the same time, newly optimistic citizens begin buying stocks again, and stock prices rise to an average P/E of 20. This means that GE will now be priced at $2 x 20 or $40. Since one business cycle takes from between 3-7 years, in seven years or less you could make a return of 267% (from $15.00 to $40). The stock market rewards patience well.
At present, company earnings are low, P/E ratios are low, and negativity is high - the perfect formula for value investing.
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“The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.”
Warren Buffett
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Disclosure
Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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