Is This A Time To Buy?

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 |  Includes: SPY
by: Plan B Economics

The S&P 500 (NYSEARCA:SPY) is down about 17% from its latest high (see first chart below), which it hit 5 months ago. Many investors are wondering if now is a good time to invest or if they should wait for the market to fall further. To save readers time, I did some digging into the past.

History can provide a framework as to what's normal and what's not normal. Of course, anyone paying attention over the past few years has learned that anything can happen, despite historical probabilities. Those that use history correctly use it to gain perspective. History is neither precedent nor predictor. Nevertheless, history does provide guideposts for the directionally-challenged. Any analysis of the present should include an exploration of history.

Test: In reviewing the current down-market, I looked at data for the S&P dating back to 1871. First, I reviewed all 1 year periods that occured after the S&P 500 had declined by 17% or more over five months (i.e. experienced a decline similar to today's).

Results: On average, the 1 year period following a 5 month decline of 17%+ saw the S&P 500 rise by only 3.82%. One year returns ranged anywhere from -60.36% to 56.48% (see chart below), and 1/3 of the returns were negative.

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Next, I looked at the earnings yield on the S&P 500 throughout history. At 6.52%, today's earnings yield has risen a lot since its low in May 2009. But is still below its long-term average of 7.48% (see chart below). Nevertheless, earnings have strengthened dramatically during the market recovery of the past couple years.

A rising earnings yield could provide a cushion under the equity markets, provided earnings don't disappear.

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Test: Again, using history to gain perspective, I looked at 1 year returns on the S&P 500 after the earnings yield for the index rose above 6.5%.

Results: When the earnings yield on the S&P 500 rose above 6.5%, the average following 1 year return was 7.22%. One year returns ranged from -51.12% to +56.48% (see chart below), and 34% of the returns were negative.

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Test: It appears as if the earnings yield has historically provided some indication of strong future returns, so I explored a little further. I broke down the historical earnings yield into buckets to see if certain levels truly provided some foresight into returns potential.

Results: I discovered that earnings yields between 8-14% were matched with a meaningfully higher average forward 1 year return of up to 8.6% (see chart below). Interestingly, earnings yields above a certain level appear to be detrimental to forward returns. Potentially because, during these periods, earnings are simply experiencing a temporary, abnormal spike.

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Click to enlarge Bottom Line Part 1: Historical data suggests that today's market decline provides few clues as to forward market performance.

Bottom Line Part 2: A robust earnings yield has historically been followed by above-average market performance. In my opinion, whether or not today's earnings yield of 6.52% will result in strong forward performance depends on the sustainability of earnings. If you think earnings can be sustained, today's earnings yield may be a positive influence for forward returns on the S&P 500. (Of course, earnings yield is only one variable in a sea of data that could influence future returns, but aggregate views are formed using many smaller pieces of information.)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This is not advice. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.