Now Is the Time to Invest and Get Rich

Or is it?

Anand Chokkavelu
Anand Chokkavelu, CFA
Dec 4, 2008 at 12:00AM
Other

Not my words. Those were Warren Buffett's. Back in 1974. He turned out to be right.

Earlier this decade, he warned about the insane valuations during the Internet bubble and the dangers of derivatives. Right and right.

A month ago, he wrote an op-ed piece in The New York Times urging investors to start buying stocks, specifically American stocks. Aside from his recent shopping spree on behalf of his company, Berkshire Hathaway (NYSE:BRK-A), he has started buying up American stocks for his personal account.  

Certainly, we should follow his lead, right?

Not so fast.

One dissenter stands out. Nouriel Roubini, the NYU economics professor famous for predicting our economy's current problems back in 2006, recently argued that "the worst is not behind us." He predicts this recession to last at least 18 to 24 months, with 9% unemployment, stag-deflation, and credit losses approaching $2 trillion.

According to his calculations, we could easily see the S&P 500 drop to 600, about 30% below where it trades today.

Who's right? Is now another time to invest and get rich? Or is the market a sucker's bet?

Buffett vs. Roubini
Before I answer those questions, let's be clear. This isn't a market-timing discussion. We Fools believe there's no proven way to consistently time the market. Even Buffett admits that he can't predict the short-term movements of the market. He thinks in years and decades, not days and months. After all, he's the guy whose favorite holding period is forever.


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Back to the question at hand. Don't be surprised if both Roubini and Buffett are right. The economy and the stock market could get worse from here, but it could still be a great time to invest and get rich.

Huh?

Remember, since we can't time the market, we're talking only about money you can keep in the market for the long term. Unlike Jim Cramer, we Fools have always said that money you need in the next three to five years should never be in the stock market. As the last year has shown, it's just too darn volatile for money you need in the short term. 

So even if Roubini is right -- the economy worsens and the stock market drops even more over the next year or two -- we could be looking back three to five years from now thinking that 2009 was a great time to invest and get rich.

OK, but how bad could it get?
Before you start putting some of your idle cash into stocks, know that it could get a whole lot worse. Fellow Fool Morgan Housel showed just how much worse in "How Low Can Stocks Go?"

Long story short, the S&P 500 has had long stretches where it has seen average price-to-earnings ratios of around 8. Even after the freefall we've seen, the S&P 500's average P/E is still at 19. Yikes! 

Of course, the trailing P/E ratio is an imperfect measure of cheapness. For example, consider that the massive negative earnings rampant in the financial sector are lowering the denominator, thus inflating that 19 figure.

Here's a place to start
Where, then, can we see some of this market cheapness Buffett is seeing? Well, Birinyi Associates forecasts the S&P 500's forward P/E ratio at just below 12, but I don't trust analyst earnings estimates to begin with, and I certainly don't trust them in the current environment. (Roubini calls 2009 consensus estimates "delusional.")

No, it's at the individual stock level where my eyes pop. We have blue-chip companies trading at minuscule P/E ratios. When I start seeing P/E ratios in the neighborhood of 10 and below, I get very interested. Take a look at these companies:

Company

P/E Ratio

Accenture (NYSE:ACN)

11.2

General Dynamics (NYSE:GD)

8.5

GE (NYSE:GE)

8.6

Aetna (NYSE:AET)

6.2

Best Buy (NYSE:BBY)

7.3

Rio Tinto

2.5

Valero (NYSE:VLO)

3.4

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

Ah, but remember my warning earlier. P/E ratios are an imperfect measure of cheapness.  They're just a place to start, because a company's future earnings can be very different from its trailing earnings. See the aforementioned losses in the financial sector. Investors looking at just the trailing earnings a year ago would have been tricked into a false bargain. Similarly, investors looking at Best Buy today should consider that its earnings this holiday quarter aren't going to be as strong as they were for last year's.

Should you buy?
Investors are clearly fearful of the future earnings of the stocks in the table above. That's why they're trading at such low P/Es. The market is throwing a sale, but it's up to you to determine which of its merchandise is worth buying.

A simple metric isn't going to cut it. That's a great place to start, but you have to do your research and determine what you believe a company's future earnings power will be. Only then can you judge whether a company is a value or a value trap.

Our Inside Value team spends its days (and sometimes nights) doing just such analysis. They break each potential stock pick down, determine its earnings power, and then figure out whether it's a good value. If you'd like to see the companies that have made their buy list, a 30-day trial is free. There's no obligation to subscribe.

Anand Chokkavelu has a P/E ratio of just 2.4 … the market will wake up one day. He owns shares in Best Buy and Accenture. Berkshire Hathaway, Best Buy, and Accenture are Motley Fool Inside Value selections. Berkshire Hathaway and Best Buy are also Stock Advisor recommendations and Motley Fool holdings. The Fool has a disclosure policy.