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3 Questions to Ask Before Buying Stocks Now

Forget seasonality - watch valuations and the Fed


Now that we’re in the Christmas holiday shopping season, you’re about to get inundated with ridiculous expressions like “Santa Claus rally” and market superstitions that would have you believe  the price action on the first trading day of the year—January 2—will determine  whether buying stocks in 2014 is a good or bad idea.

It’s hard to believe that grown men and women peddle nonsense like this, but the financial press is flooded with it every year. And some people actually use these seasonal trends to decide whether buying stocks is a good or a bad idea.

To be fair, December and January tend to be good months in the market, with average returns of 1.8% and 1.7%, respectively, according to a study that Ken Fisher did in The Only Three Questions That Count. But July was the best period for buying stocks, with returns for the month at 1.9% making “sell in May” look like pretty terrible advice.

My advice?  Ignore these little bits of Wall Street “wisdom” as they pop up when you think about buying stocks.  Market seasonal patterns, to the extent that they exist at all, are by no means guaranteed, and in most cases are not investable. For most investors, whatever they gain in added return due to over- or under-weighting based on seasonal patterns will be more than lost in taxes and trading expenses.

Instead, I suggest you ask yourself the following questions before you invest:

  1. Is the market or are the individual stocks in which you are investing reasonably priced?
  2. How is investor sentiment towards stocks in general and in your stocks specifically?

And in today’s market, I would add a third question: How might the Fed’s actions affect your portfolio?

The first question, “reasonably priced” is subjective.  What is a reasonable valuation under some conditions might be completely unreasonable under others. For example, the S&P 500 trades for about 19 times trailing earnings and at a Shiller cyclically-adjusted P/E ratio of about 25.

In an environment of high inflation and high bond yields, that would be a ludicrously high valuation. But in an environment in which the 10-year Treasury yields less than 3% and the 30-year yields less than 4%, a P/E of 19 (which equates to an “earnings yield” of 5.2%)  is “reasonable,” even if not especially cheap.

Investor sentiment is a somewhat nebulous concept and one that is hard to quantify.  You can use metrics such as the AAII survey, mutual fund inflow data, or assorted put/call ratios, but generally speaking these tend to be short-term indicators and tend to have a lot of noise.

I find that the “water cooler” indicator is generally pretty effective as a broad gauge of sentiment.  If you notice friends and coworkers showing uncharacteristic interest in the market or in a particular stock, then take that as a warning that stocks are getting broadly over-owned.

By this informal gauge, I see little indication of extreme optimism among investors.  They’ve come out of their post-2008 deep freeze, but I haven’t seen the man on the street throw caution to the wind … at least not yet.

And finally, we get to the Fed.  The Fed may start tapering its quantitative easing program before the end of the year, though I expect the tapering to start late in the fourth quarter and to start slowly.  Short-term rates will stay at near zero for the foreseeable future, however, and I expect inflation to be tame.  This is a long way of saying that I expect the Fed’s action to be roughly neutral, neither a headwind nor a tailwind.

Based on valuation and sentiment, I am comfortable being invested in U.S. equities going in to 2014.  I do, however, see far better values in Europe and in emerging markets.  As I wrote recently, U.S. stocks are priced to return about 2% per year going forward.  But Spain and Italy are both priced to deliver annual returns of over 10%, and China is priced to deliver even better returns.

If you want to play the coming rally with ETFs, I have two to recommend: the iShares MSCI Spain ETF (EWP) and the iShares China Large Cap ETF (FXI). Both have spent most of the last two months in correction. That’s OK. I recommend using the weakness as an opportunity to accumulate more shares.

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