Is It Time to Get Back Into Stocks?

Surely this must be another sign of investor confidence, confirming that it's time to get back into stocks. Wall Street was watching the VIX closely on Tuesday. When it closed below 30 for the first time since the bankruptcy of Lehman Brothers, the event was immediately hailed as a bullish indicator.

The VIX index, commonly referred to as the “fear gauge” on Wall Street, reflects the market's expectation for future stock volatility. The index is derived from the prices of options on the S&P 500. Because future volatility is the only unknown input in the Black-Scholes formula for pricing options, it's possible to work back from the market prices for options to find option buyers' estimate of volatility.

Where we've been, where we are
From late 2007 through mid-2008, the VIX was in a range between 20 and 30, but it exploded after the Lehman bankruptcy, reaching an all-time high of 89.53 in October. Option buyers were furiously bidding up puts, desperate to obtain protection against stock price declines.

However, the VIX has declined steadily since March, despite the fact that stocks have been volatile (see table below), with the S&P 500 gaining more than 30% since its March 9 closing low. Not all volatility is created equal: It lulls investors on the upside, but downside volatility triggers a fight-or-flight response.

Stock

% Return From March 9 Stock Market Low*

Office Depot (NYSE: ODP  )

531%

Genworth Financial (NYSE: GNW  )

468%

Fifth Third Bancorp (Nasdaq: FITB  )

455%

American International Group (NYSE: AIG  )

409%

Huntington Bancshares (Nasdaq: HBAN  )

346%

Hartford Financial (NYSE: HIG  )

283%

SPDR S&P 500 ETF (NYSE: SPY  )

34%

*Returns at May 20, 2009.
Source: Standard & Poor’s Capital IQ.

Banks get comfortable
This "feel-good" milestone for the VIX comes on the back of several other signs that the capital markets are returning to normalcy. Last week, the TED spread, the difference between what banks and the U.S. Treasury pay to borrow over three months, fell to its lowest level since Aug. 8, 2007 (the next day, French bank BNP Paribas halted redemptions for three of its funds, citing losses on subprime mortgages -- one of the catalysts for the credit crisis).

Similarly, three-month U.S. dollar LIBOR, the rate at which banks lend to each other, fell to 0.7525% -- its lowest level since 1986, the year the British Bankers Association began publishing dollar LIBOR rates.

Both of these lows indicate that banks are becoming much more comfortable lending to each other. That's a critical condition for credit to flow normally from the financial system to the rest of the economy. As we've become all too aware of during this crisis, credit is a key cog in facilitating economic growth.

Is now a good time?
Does this mean that investors can now feel confident in getting back into the market? To answer that question, let's take a look at a valuation measure rather than the VIX, which is a technical indicator of investor sentiment.

Based on yesterday's closing price of 903.47, the S&P 500 is trading at 15.6 times average real earnings for the last 10 years (sometimes labeled the cyclically-adjusted P/E ratio, or CAPE). That is certainly less mouth-watering than the 11.7 times the index reached on March 9; however, data from Yale University's Robert Shiller shows that it is about in line with the 16.3 average multiple for stocks going back to 1881.

The prospect of reasonable returns
These numbers suggest that stocks are no longer superbly cheap, but they do offer the prospect of reasonable returns (say, 6% to 7.5% annualized after inflation) for long-term investors. Asset management firm GMO, which follows a fundamental orientation, estimated that large-capitalization U.S. stocks would return 7.5% annualized real returns, compared to the long-term historical average of 6.5%. Mind you, those estimates were as of the end of March, with the S&P 500 one hundred-odd points lower than it today and the CAPE at 13.8.

(By the way, the chairman of GMO, Jeremy Grantham, is a fan of the cyclically-adjusted P/E ratio.)

Walk, don't run
If your time horizon is adequate, those expectations dictate a significant exposure to stocks. Still, that isn't a prescription for rushed or indiscriminate action (if you have no exposure to stocks, I definitely think it's presently worth revisiting your rationale). Investors can add to their equity holdings incrementally as valuations become more attractive, and I think there are good odds that we'll witness stock price declines to get us back to or near the low achieved in March (or possibly even below -- the cyclically-adjusted P/E has bottomed out below 10 during prior crises).

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. The Fool owns shares of SPDRs. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (32)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 21, 2009, at 5:00 PM, FinancialFellow wrote:

    I don't think there was a time where long term investors should have ever left stocks. So, I don't think this is a question many long term investors will need to answer. For others that move in and out of the market, however, I'd suggest now is a good time to get back into the market. Could the market head south for a little while? Yes. That said stocks are still very cheap and I believe that folks that get in now and hold their stocks for a few years will see pretty solid gains.

    In the meantime if you have a couple extra bucks to spare I'd like to suggest an investment that offers up a 0% return: http://financialfellow.com/2009/05/18/the-best-0-return-youl...

  • Report this Comment On May 21, 2009, at 5:18 PM, wuff3t wrote:

    Financialfellow,

    Do I read that right? Are you trying to entice people in with a 0% return?

    Okay, maybe if you read the link it sounds better but as an advert...?!

  • Report this Comment On May 21, 2009, at 9:11 PM, TxTom wrote:

    Is it time to get back into stocks? Sure. I liked stocks the minute that our government backstopped all the major banks. At that time Citigroup was $1, FITB was $1.10, BAC was around $3, etc. My battered IRA was restored within a month, and the rest is post-recession gains.

    I still like banks. They borrow at zero, lend at whatever they want, and are dying to pay back TARP funds, which they will do in short order. Citigroup in particular is still way undervalued, regardless of government funds pumped into this bank, and will continue to move upward, as will BAC and others (like JEF). "Long term investing" is about three months in this market (or when your return is met). Then move onto the next recovering stock or sector. This market will be fun for at least the next year or so.

    Just watch your favorite stocks, the market in general, and heed political developments. Something is popping at all times these days. Traditional methods of investing lose value during this time that most "experts" have never seen before. Pundits that claim to know how to invest are proven wrong every day (have you noticed?). Hey, just listen to them and do the opposite. It works for me. Anyone that can't make money at this time isn't paying attention. And I don't mean attention to all the "talking heads" on TV. "They know NOTHING"....Fool on......

  • Report this Comment On May 22, 2009, at 12:01 AM, olivia061405 wrote:

    TxTom,

    Are you serious, "They (banks) borrow at zero, lend at whatever they want, and are dying to pay back TARP funds, which they will do in short order"

    Who are you talking about? The capital markets or the chocolate jesus's treasury owned arm of reparations for blacks and social justice to the lazy and complacent? Have you been to the DMV? Do you think that the wizards of smart in our lovely government won't claim stock in GMAC or other banks and take over. NOTHING THE GOVERNMENT TOUCHES WORKS. !!!!!!!! Meaning all the banks you love will be CONTROLLED ONE WAY OR THE OTHER. Why to do think they have not been able to pay back TARP yet you fool? You bet on bureaucracy all you want, I will take the commy chineses market before Barry O Bambastic the power grabbing business dink who has never run a profit generating entity in his life. Wait til inflation hits and all hell breaks loose.

    Good luck and the re-read the 3 blind mice fairy tail.

    Let me guess, you are under 40

  • Report this Comment On May 22, 2009, at 2:34 AM, dquihote wrote:

    FinancialFellow, I think you are right - for people with a long-term INVESTING portfolio, there was never a time to be out of stocks.

    For people who invest regularly, perform their own due diligence and know the companies they are investing in, market timing is NOT a question.

    What is bothersome about this article and a lot of others I have seen recently (both on MF and in other media) is that it seems people are trying to make money from "feel-good" indicators. While this may work for a while, or occasionally, it will not work consistently. EVERY investor bears the burden of knowing what they are investing in... commonly known as "due diligence". If you don't have time to do the research yourself - or hire someone that YOU TRUST to do it for you - then I would suggest that you are not investing, you are simply buying stocks and gambling that the price will go the direction you want it to go.

  • Report this Comment On May 22, 2009, at 9:38 AM, pberardi wrote:

    There are many reasons why we got into this mess and there are many reasons why we won't get out of it.

    Yes the bear market has created some buy opportunities of a lifetime and I've been a buyer since last summer. I think the time is always right during a major decline to buy good companies on sale.

    The problem is my expectations (rightfully so) are extremely low for the next 10 years and perhaps the next generation if we don't get serious about the following:

    Gov't spending as a % of GDP will approach 45%. That puts us into Scandanavian territory and based on history, is a guarantee for slow economic growth.

    It is too late IMO to save SS & Medicare. They will explode and force us into much higher taxes which will cramp spending and economic growth.

    Nationalized healthcare will curtail one of the few remaining growth sectors in our economy. 17% of GDP goes to healthcare so expect unemployment, outsourcing and the destruction of innovation in biotech amd pharmaceuticals.

    Detroit is gone and so are the industries that make their living off of the big 3.

    Point is too much government weighing on the private sector, too much central planning, hyperinflation created by too much government and higher interest rates are the future for our nation.

    Never in my life have I lost so much hope for my country. We've become a socially weak and inept society that can no longer tough out a recession and we elected socialists to deliver the huge safety net we now prefer over good ol' fashion American ingenuity.

    It is quite disturbing that in order to achieve the American dream one must seriously contemplate investing large sums of money in emerging markets and seriously consider working and starting businesses overseas.

    America, thanks to the left, has become a lousy place to do business and eventually our workforce will become more and more european.

    As the environmental movement takes control of our failing economy, nations like Brazil and China who are willing and able to do the dirty work needed to feed and build a world economy will become economic power houses.

    Americans are foolish to believe that simply destroying industries that create carbon such as coal, energy and manufacturing will eliminate the need for coal, energy and manufactured goods to live and enjoy a modern day life.

    All it means is that we will pay someone else to create wealth at very high prices and high unemployment.

    Wake up America! If you want a rising stock market we need a rising economy that is market driven.

    No economic growth means no jobs which means no corporate profits which means our stock market is already over valued.

  • Report this Comment On May 22, 2009, at 9:39 AM, TxTom wrote:

    olivia061405....

    It isn't whether government involvement is desired or not. It is a fact today. Take the facts, use them to your advantage, and make money. Isn't that why we are in the stock market? Not bragging, but my portfolio is up 175% in two months using this approach. You can argue with my philosophy, but the profit is there in black and white (all black now). What I am doing works, and to me that's the important thing.

    We have no idea of how terrible this economy might have been today if we didn't have the present administration. I voted for Obama, and I've not been disappointed at all. At least he takes action and then modifies items as needed. That's a drastic departure from anything I've seen during my lifetime when it comes to a US President.

    And no, I haven't seen 40 for 25 years now. Well, except for the 40+ percent gains I've had in numerous stocks - several of them more than once.

    But do what makes sense, put a stop-loss on any stock when it surpasses your expectations, and don't be afraid of banks. Where are they going from here, down? I seriously doubt it (other than occasional dips). And those are buying opportunities.

    If you believe C will go down more than a few percent, then stay away from the stock. If you think the upside is north of $10 per share over this next year, you'll do well in my opinion. And we all have an opinion, don't we?

    If you have a formula for doing better than that, please share it with all of us. We listen to EVERYTHING, and then make our decisions independently.

    But I do appreciate hearing your point of view.

    Good luck, everyone. This will be a wonderful year.

  • Report this Comment On May 22, 2009, at 11:44 AM, TxTom wrote:

    For those of you who may not have seen this article yet...

    Banks are coming back in a big way.

    NEW YORK (Dow Jones)--Large bank stocks are set to rise over the next year or two as the pace of economic decline begins to slow, Morgan Stanley analysts said Friday.

    The firm raised its price target on the 16 large bank stocks it covers by an average of 33% and said that most would be able to repay TARP money by the fourth quarter; it raised its price target for Bank of America Corp. (BAC) 28% to $32, Citigroup Inc. (C) 50% to $6, JPMorgan Chase & Co. (JPM) 33% to $60 and Wells Fargo & Co. (WFC) 33% to $44.

    Happy trading folks!!

  • Report this Comment On May 25, 2009, at 2:51 PM, salvadorveiga wrote:

    for long term investors I rather be an investor when a trend is on my side... long term trend is down !

    I will love to buy stocks in 2012-2013, stocks that today trade at 20 USD will be at single digits or on the cents !

    S&P 300 points here we come....

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