The Third Pig

Benjamin Graham’s proverbial Mr. Market is manic depressive and thusly causes much of the daily up, then down, then up again movements in stock prices. When pessimism pervades, Mr. Market will be so eager to sell his shares he will eagerly drive down stock prices to levels that make little sense. We saw Mr. Market do that over the last couple of weeks, driving the S&P 500 down 28% in just 14 days.

Mr. Market was so depressed in fact and so willing to sell, the CBOE VIX Index reached record proportions, topping 50 for the first time since it started measuring all 500 stock of the S&P Index. However, in his haste, Mr. Market has thrown the baby out with the bath water. Values abound as an article in the Wall Street Journal by Jason Zwieg points out:

“Out of 9,194 stocks tracked by Standard & Poor's Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year -- or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash…”

Zwieg also points to a Benjamin Graham measure of valuing the stock market adopted by Yale professor, Robert Shiller, is at its lowest levels since 1989. The Graham P/E divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation. At Friday’s close, when the S&P 500 was 899.22, the Graham P/E stood at less than 15 times earnings. This is good news for those on the other end of Mr. Market’s transactions.

But low and behold, Mr. Market heard some good news over the weekend that the world’s governments were doing all they could to handle the credit crisis. Mr. Market became irrationally exuberant, deciding to buy back all the stocks he had sold the two weeks prior. Today, the S&P 500 gained 11.6% - the highest percentage gain since 1933 – settling at 1003.35.

With the today’s advance, long-term investors might fear all the values Mr. Market left us last week have disappeared. I doubt this is the case. For the S&P 500 to return to its previous high of 1576.09, stocks would have to gain nearly 60% from current levels. Under “normal” circumstances, it takes nearly 5 years to gain 60% in stocks. In other words, the bargains will remain for some time. And as the following chart points out, returns to previous highs can take years. [Click image for larger view.]

In the meantime, for long-term investors, it is best to heed Jack Bogle’s advice [video]:

“Visualize investment as growing as a steady line, which it does [red lines in charts below], and visualize the crazy market as being all these jags up and down and around this steady line [blue lines in charts below], upward, upward, always upward, I think, then you’ve got to say, I know I’m not smart enough to get out at the high, I know I’m not smart enough to get back in at the low, so I’m just going to stay the course… what you want to do is keep investing…”

Bottom line is, while this is a scary time to be in the market, it is best to simply keep plugging along. No one will know where the bottom of the market is and it is equally hard to know where the top is. But Mr. Market will always be willing to give you a clue as to what you should do. Buy when he’s selling and sell when he’s buying.