Is the Dow headed sharply up or down in the near future?

I don't know. Don't be disappointed, though -- no one knows (though that doesn't stop plenty of folks from offering an opinion).

What I do know
It's impossible for anyone to correctly (or consistently) predict where the stock market is headed in the short term. Sure, some pundits make some seemingly great calls now and then -- but given all the pundits out there, it's kind of inevitable that occasionally someone will be right on the money. (As one of my business school professors once quipped, even a blind pig finds an acorn now and then. Or, even a broken clock is correct twice a day.)

Instead of trying to guess the future, though, let's look at the only guide we have now: history. I do know that in good markets and bad, over long periods of time, the stock market has gone up. Sure, there have been some big spikes up and down -- especially lately! -- and also some long periods of stagnation. But overall, the trend is up. Specifically, the average annual gain for the stock market has been around 10% over many decades.

Your investing period, whether you end up invested in stocks for 17 years or 33 years or what have you, will probably have a different average annual return, but 10% is the market's long-run average annual gain, and that's enough to turn a $25,000 nest egg into more than $430,000 in 30 years, enough to turn $50,000 into more than $540,000 in 25 years. Enough to turn a mere $10,000 into nearly $1.2 million in 50 years. (Don't laugh -- set your teenager up for a comfy retirement right now, with a $10,000 gift.)

What else I know
There's no telling whether stocks will return 10% over the next decades, of course. But not knowing that -- and not knowing if the Dow will be at 5,000 or 20,000 next year -- shouldn't preclude us from investing anyway. Not those of us who are business-focused investors, at least.

After all, who wants to invest based on where they think an index of 30 big companies will be by the end of next year? Invest based on bottoms-up, fundamental analysis, because you'll always have better odds of finding stocks that are being undervalued by the market.

What to do
Finding undervalued stocks is easier said than done, sure, but over long periods, value investing has proven itself a hard approach to beat. Whether the Dow is heading down to 5,000 or up to 20,000 next, it can serve you well, helping you zero in on companies that are undervalued in all kinds of economic environments. Don't believe me? Look at the numbers. Data from Fama and French have shown that between 1927 and 2004, value stocks, both large-cap and small-cap sized, have outperformed growth stocks by between about 3 and 6 percentage points -- that's a huge difference.

So where should you go hunting for "value" stocks? Well, I'd recommend looking for a few measures I use:

  • Price-to-earnings (P/E) ratios well below companies' historic averages.
  • Low price-to-free cash flow (PFCF) ratios.
  • Low price-to-book (P/B) ratio (though book value is more relevant for companies where you want to see growing assets, such as banks; it's not so helpful for companies that are light on physical assets and heavy on intellectual assets, like software companies).

If a company has no earnings with which to compute a P/E ratio, consider the price-to-sales ratio as a substitute. Just remember that it's always best to look at lots of numbers, not just one or two, and that each metric has its ups and downs. So take some time to learn more about them.

To get you started, below I've presented a few companies that meet the first of the above criteria -- companies with recent P/E ratios well below their five-year averages. This is just one metric, but it might serve as a starting point for your research:


Recent P/E

5-Year Average P/E

Microsoft (NASDAQ:MSFT)



Chevron (NYSE:CVX)



Cisco Systems (NASDAQ:CSCO)



GlaxoSmithKline (NYSE:GSK)












Source: Morningstar.

Even if you don't have the time or energy to study the universe of stocks, you can win. Permit me to invite you to test-drive our Motley Fool Inside Value newsletter, which features two thoroughly researched recommendations each month. A free trial will give you access to all past issues and all recommended stocks.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article, but she does enjoy General Mills's Lucky Charms cereal. Microsoft, 3M, and Intel are Motley Fool Inside Value recommendations. GlaxoSmithKline is an Income Investor pick. The Motley Fool is Fools writing for Fools.