Is Now A Good Time for the S&P?

The S&P 500 has recently fallen to levels unseen since the start of the Iraq War in 2003.  The question is, are investors better or worse off owning it?

The index, readily available through the SPDRs (AMEX:SPY) ETF or Vanguard’s 500 Index (VFINX) mutual fund, is considered the standard-bearer for U.S. equity performance. Since the index represents more than 70% of the market value of U.S.-based publicly traded companies, you need a pretty good feeling about the future of American business to park your hard-earned dough in it. With that in mind, is the outlook for the Index better now than it was five years ago?

At the end of the first quarter of 2003, the price-to-earnings (“P/E”) ratio for the S&P stood at 28, as the S&P hovered right below the 900 mark. Fast-forward to today, and you can buy the index at similar levels. The difference is that the S&P is now sporting a P/E of approximately half of what it was in early 2003. 

Despite lower P/E levels, market volatility has recently reached historical highs. For perspective, October 2003 saw the CBOE Volatility Index (“VIX”) hover between 17 and 23; recent levels surpassed 60. The VIX, affectionately referred to as “the fear index,” gauges volatility, uncertainty, and most importantly, fear. So you could say that investors are twice as uncertain now than they were in 2003, when the S&P index was twice as expensive.

Granted, uncertainty hangs over both the global economy and the reliability of future corporate earnings. Investors with the stomach to confront the market must decide whether they want to ride a market index or go stock picking for bargains. On this point, investors may be well-served to take a word or two of advice from Warren Buffett.

Buffett’s case for index investing
Warren Buffett has often stated his belief that small investors without the time to research individual stocks should simply invest in low-cost S&P funds. "If you buy it over time, you won't buy at the bottom, but you won't buy it all at the top either," Buffett says. Academic research, time and time again, has chronicled the failure of individual investors to profitably time stock-market entries and exits. Investors are too apt to chase near-term performance to their demise, often buying high and selling low.

Known as a man of action -- at least investingwise -- Buffett has recently put his money where his mouth is. First, Buffett's big bet has the Oracle wagering his own money on the belief that the Index will outperform a select number of hedge funds over the next 10 years. Second, Buffett has pulled in $4.5 billion in premiums for Berkshire in exchange for the promise to pay out only if the Index is lower more than a decade from now. 

Buffett’s case for individual investing
While Buffett is wagering on the long-term growth of the S&P, we’ve found someone pushing his own chips in on competing advice. Who would dare? None other than Warren Buffett himself.

Buffett, so confident in the long-term prospects of equities, has penned a New York Times article urging Americans to follow his lead and buy stocks. Remember, this is the same man who famously made the bold guarantee that he could earn 50% annual profits by investing in a portfolio of tiny, undiscovered, and thinly traded stocks that you or I have daily access to.

Let’s be clear: To essentially double your investment every 20.5 months, you can't buy an index fund. Even the most promising diversified stocks in the S&P, like Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG), are too big to break the law of large numbers and grow at market-thumping rates.

A quick stock screen reveals over 200 companies with 12-month returns in excess of 50%. Over 95% had market caps below $1 billion. The table lists just a few from the top.

*Data from Morningstar and Yahoo Finance as of Oct. 20, 2008.

While 12-month returns are no indication of long-term performance, it does show that hidden gems abound, and they often lie in small, undiscovered individual stocks.

Buffett versus Buffett
So which Buffett should you listen to? It depends. Simply put, Buffett understands that knowing oneself is the real underlying key to successful investing. Whether you choose to invest in an index fund or an individual stock really depends on your available time, valuation skills, and personal temperament.

Either way, you're better served by investing consistently versus trying to time the market. You simply have to decide whether you're more suited for a life of index-level returns, or whether you have what it takes to navigate stormy markets to outsized returns. Just know thyself, and remember, we're here to help.

For Related Foolishness:

• An Investor's Finest Hour
• Fool Poll: Are You Staying in the Market?
• The Truth Behind Buffett's Big Bet