How to profit in a falling market

With the TSX down 15% from its 52-week high, the mood in the markets is fearful. Does that mean it’s time to panic? Not at all. The secret to making money in a falling market is to wait until prices have fallen far enough. That’s when savvy value investors pounce. The key is to buy your stocks cheap, so they have nowhere to go but up.

The real question is whether prices are low enough yet. To deduce that, I like to turn to economist Robert Shiller’s price/earnings ratio (P/E) for the S&P 500 to value the general state of U.S. stock markets because it provides a useful long-term guidepost. Shiller’s P/E is the ratio between current prices and average earnings over the last 10 years, the idea being that you can get a better sense of the long-term trend via 10-year average earnings rather than by short-term figures.

The graph to the right shows the history of Shiller’s P/E for the S&P 500. You’ll notice that the ratio is currently 19.7, which is high compared to its historical norm of 16.4. As a result, U.S. stocks could still have farther to fall. The situation in Canada isn’t much better, with Canadian stocks at fairly high levels. Even worse, we tend to be more exposed to downturns, due to the cyclical nature of much of our economy.

Those with a more bullish bent will point out that stocks have traded at far higher levels in the past. Also, the huge earnings collapse of 2008 was unusual—the lower earnings over the last decade might provide an overly bearish reading. As a result, Shiller’s P/E could be somewhat inflated.

Nonetheless, I think stock markets as a whole are not overly cheap. (Thankfully there are still a few bargain stocks to be had.) I also don’t feel nearly fearful enough. As a result, I don’t expect to shift my asset allocation toward stocks at this point. I’ll wait for better valuations and a bit of stark terror before making any dramatic moves.