Is the Market Cheap? Does It Matter?

A reader left a comment that gave a reasonable "I hear ya but..." approach regarding the 200 day moving average. It seems three out of four timing indicators that Phil DeMuth and Ben Stein use say the S&P 500 is now undervalued.

(Let me be clear: I don't know anything about what Stein and DeMuth are saying. If anything, I am relaying the reader's comment and choose to believe the reader has his facts straight.)

I have written about this sort of thing before. The Fed Model is an example of the type of market valuation process the reader is talking about.

All indicators of all types have flaws. If you are going to to rely on an indicator, you have to know its flaws in order to make an intelligent decision based on it.

First, let's stipulate that Stein and DeMuth's indicators are correct and the market is cheap. OK, when will it go up? Will it get cheaper? What about being cheap will lead to a move in the market? Is cheap important right now? Do the risks that made it cheap in the first place outweigh the cheapness?

Every model along these lines I have ever seen can stay cheap or expensive for years - the market continues to move up while expensive, or down when cheap.

My take on the 200 DMA is that the dynamics of the market are communicating the health of demand. Quite simply, if demand is healthy the market stands a better chance of doing well, regardless of how cheap it is. The drawback is that occasionally it will breach the 200 DMA in one direction for only a couple of days and then go right back - which is a reason why I don't make big bets all at once but just start with a tweak.

The way I look at it, valuation models/indicators rely on too many "shoulds." I don't find anything forward-looking when armed with the knowledge that stocks are cheap. Additionally, "Is demand healthy - yes or no?" is a much simpler concept and where possible I think simpler is better.

Comments

[User 124892:]

The market will be cheap when it gets down to 5500 on the dow.

2008 Feb 13 11:24 AM

[locke:]

For an investor, it most certainly does matter if the market is cheap. For a short-term trader, it does not matter.

Not everyone here trades twenty times per day. Some of us are looking for good times to buy a stock and hold it until retirement. In the long run, it is better to buy a cheap stock than an expensive one, regardless of what happens next week or next month.

2008 Feb 13 02:51 PM

[Roger Nusbaum:]

if all you own are "cheap" stocks you probably do not have a diversified portfolio. Cheap does not always do best. The notion of cheap seems like the wrong priority.

Own some of every sector, many different countries, various cap sizes, both styles, varying volatilities, and some cheap and some expensive.

2008 Feb 13 09:06 PM

[DougM:]

I can give you one catalyst: the tons of cash that is currently on the sidelines, hiding out in US treasuries earning negative real returns. When the market looks like it has less downside than cash, the money could flow into stocks. The fed is taking rates down down down. When they hit 2%, stocks will look even cheaper.

2008 Feb 13 10:33 PM

[User18358:]

Roger, spoken like a true trader. The small investor should diversify, while I'll keep trading...

2008 Feb 14 12:08 PM