Chances are that you may not have taken a read of the PE ratio lately or perhaps thought about its impact on the performance of your stock market portfolio.
Both are historically high which means it demands your attention as a good steward of your equity exposure.
But rather than panicking or entertaining the mistaken belief that prices will continue to go higher ad infinitum, simply choose to manage your portfolio in such a way that you’re able to take advantage of stock market prices when they are high.
Why are stock market valuations so high?
Its the Fed.
The whole Fed.
And nothing but the Fed.
Even before the current Fed chairman Jerome Powell was sworn in February 2018 , the central bank began raising interest rates in 2017 and indicated that it would continue to raise rates throughout 2018.
As Powell continued to raise rates in 2018 investors began to question the feds policy of monetary tightening and started to vote with their feet out of stocks and into safer assets leading to corrections in the stock market in the 4th quarter.
A correction is defined as a 10% decline in one of the major U.S. stock indexes, typically the S&P 500 or Dow Jones Industrial Average, from a recent 52-week high close.Thomas Franck, CNBC
Since then the worldwide coronavirus pandemic has spurred the Federal Reserve into enacting a plethora of measures to help support the US economy including reducing interest rates and a massive quantitative easing program.
The stock market has duly followed an upward trajectory in kind as investors piled back into stocks after what they see as a lifeline for the stock market from the Federal Reserve.
How the PE ratio can help your stock market returns
A simple rule of thumb is if the PE ratio is high then raise cash in your portfolio.
If the PE ratio is low then the general market is cheap and there are more bargains around to pick up at a discount.
This simple but effective portfolio management technique can get you out of stocks when they are expensive and get you in when they are cheap.
The difficulty lies in actually following through with this style of investing as it’s counterintuitive to how human beings behave.
Take the corrections of late 2018.
By the time the new year hit the S&P 500 was down to 2,500 with a PE ratio of 19.6 when most investors were getting out of stocks.
The Fed announced on 30th January 2019 that it would stop raising interest rates for the remainder of that year which sent stocks soaring for the rest of 2019.
Recent indicators point to slower growth of household spending and business fixed investment in the first quarterJerome Powell, Chairman, Federal Reserve
It is impossible to predict the policy of the Federal Reserve or what interest rates might be in the future and it is undoubtedly difficult for most people to buy stocks when everyone else is selling them so this style of portfolio management is not for everyone.
But an old school Grahamite value orientated approach to stock market investing that seeks to preserve capital so that you can fight another day is the bedrock to a successful portfolio management framework.
Take advantage of stock market prices when they are at their cheapest when the equity of quality companies are at a discount at these lower price levels.