How to Follow Buffett in Today's Market

Fear. There simply isn't enough of it to go around these days. The VIX -- Wall Street's "fear gauge" -- closed at 26.08 yesterday. It reflects investors' expectations for future stock market volatility, and prior to the second half of November, we hadn't seen such low values since early September 2008 -- the pre-Lehman bankruptcy era.

Why should investors care about this seemingly arcane number? As Warren Buffett wrote in an October 2008 New York Times op-ed column: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."

Applying Buffett's rule
In that opinion piece, Buffett exhorted investors to buy on the rationale that "fear is now widespread."

What a difference 17 months makes! With much of the fear out of the market, investors' temperament now appears tipped toward greed. The VIX isn't the only indicator of this -- any decent market observer should be tripping over the signs -- and it's by no means a U.S.-centric phenomenon, either. Buffett's rule now suggests that, rather than buying heavily, prudent investors should favor caution.

But not all parts of the market point to investor complacency. According to data compiled by U.K. bank Barclays and Bloomberg, at the beginning of December, the difference in price between one-month and one-year options on the S&P 500 was higher than at any time since 1999, highlighting investor concern that analyst estimates of record earnings by 2011 are overoptimistic.

The earnings risk hanging over the U.S. market
Analysts are now calling for a 20% increase in S&P 500 earnings in each of the next two years -- the highest rate since 1994.

The scope of this enthusiasm becomes apparent at the company level. Just look at the following companies, which have seen their earnings estimates surge over the past 12 months:

Company

12-Month % Change in Consensus Fiscal Year 2010 EPS Estimate

Forward P/E (Current Fiscal Year Estimated Earnings)

Texas Instruments (NYSE: TXN  )

201%

11.5

Apple (Nasdaq: AAPL  )

97%

16.9

Goldman Sachs (NYSE: GS  )

47%

8.7

Alcoa (NYSE: AA  )

42%

15.4

BestBuy (NYSE: BBY  )

32%

11.9

Capital One Financial (NYSE: COF  )

29%

17.4

Intuitive Surgical (Nasdaq: ISRG  )

23%

43.1

Source: Capital IQ, a division of Standard & Poor's.

This certainly appears inconsistent with an economy in which consumer credit remains tight and unemployment remains elevated. Speaking at the Economic Club in Washington on Dec. 7, Fed chief Ben Bernanke -- who's hardly an inveterate bear -- said "we still have some way to go before we can be assured that the recovery will be self-sustaining."

In fact, although the forward P/E of the S&P 500 looks quite reasonable at 14.2, a more reliable multiple tells a different story altogether. According to data compiled by Professor Robert Shiller of Yale, the S&P 500 is trading at a cyclically adjusted price-to-earnings (CAPE) multiple of nearly 20, more than 20% above its long-term historical average (the CAPE compares price to the average inflation-adjusted earnings over the prior 10-year period).

In other words, the U.S. market is overvalued.

Two strategies in an overbought market
Given that the market is overvalued, investors are left with two alternatives:

  • If you are mainly an index investor (i.e., your exposure to U.S. stocks is through index mutual funds or ETFs), you should be underweight the broad U.S. market.
  • If you prefer to invest in individual stocks, it is acceptable for your portfolio to carry a normal weighting in equities if the names in your portfolio are no more than fairly valued (it's preferable that they carry a margin of safety).

In short, valuation is key, because it drives returns over the long term.

Stockpickers: Valuations are vital
If you're not following one of these two strategies -- both of which are driven by valuation -- you may currently be at risk of suffering unacceptable (and unnecessary) capital losses.

The team at Motley Fool Inside Value is always focused on valuation. They can show you how to build and manage a portfolio around 8 "Core Stocks" -- rock-solid businesses with attractive growth prospects that have the potential to underpin healthy, low-risk returns in your portfolio over the next decade. If you'd like to find out more about these Core Stocks, as well as Inside Value's six "Best Buys Now," sign up for a 30-day free trial today by clicking here.

This article was first published on Dec. 11, 2009. It has been updated.

You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Best Buy is a Motley Fool Inside Value choice. Intuitive Surgical is a Rule Breakers recommendation. Apple and Best Buy are Stock Advisor picks. The Fool owns shares of Best Buy. Try any of our Foolish newsletters today, free for 30 days.


Read/Post Comments (3) | Recommend This Article (7)

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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 February 05, 2010, at 11:29 AM, acbill wrote:

    this drop is all about selling call options. the market will likely not go higher until after feb options expiration. the mob on pennsylvania ave is setting this up orchestrated by the big dog in da house who announces what he's told to for the sole benefit of his buddies. all the little guys who were long will get killed again untill they have to bail and then the mob will buy the market back up. the market is nothing butba day traders racket these days. the times of investing in good american companies is gone and you will never make $ against the mob with there auto trading programs and their talking head puppets in washington. they know what your positions are and they are out to break all the mom & pops and steal their retirement $. homework will not save you or serve you because price action is not based on a companies performance anymore. if you got back to even or close during the run up it's best to get out and bet on sports or horses or tiddlywinks where at least you have a chance. disgusted with the mob and their talking head puppets? let's see what happens when the easy prey is wiped out of the market and they can only steal from each other. off with their stinking heads!

  • Report this Comment On February 05, 2010, at 2:25 PM, Pandorabelle wrote:

    I agree with you that the mob of day traders is causing a lot more volatility, however I refuse to be beaten. Thanks in large part to MF info and guidance, I have turned 38K into 190K since 3/2/09--when I dove in.

    I've chosen holdings valued for the long haul-most paying dividends and several are MF recommendations. With this in mind, I have taken matters into my own hands and spent the last month researching options strategies until I thought my brain would explode.

    While I never expect to day trade professionally, I have learned how to defend my gains when the market turns. I wrote 15 Feb-10 COVERED CALLS today to the tune of 7.5K.

    My strategy is this (which is likely the typical shorting stragegy!):

    Buy positions in lots of 100 so I can write covered calls on them. Choose a strike price I would be willing to sell and still keep gains. If I end up being called to sell, I can buy back and will at least be able to keep the premiums. Ideally I don't want to realize gains if I can help it...but I'd rather pay tax than on earnings than lose them!

    We can't change the greedy bone-heads...but we can use knowledge to protect ourselves. I'm ignoring everyone else and finding a way to make it work for me...and you can too.

  • Report this Comment On February 05, 2010, at 2:29 PM, Pandorabelle wrote:

    PS...to follow Buffet, I am being "greedy" and buying more every time the indexes tank (when others are "fearful" - !)

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