For now, investors are worried about the slow pace of economic growth, the rapid spread of growth in government and the negative effects these two factors will have on earnings. Yet in a world where good news seems impossible to find, stocks prices are moving higher.
Investors often confuse companies with stocks. They are very different and in the end we buy and sell stocks, not companies. One underlying principle that many investors overlook is that good companies can have good stocks, but bad companies can also have good stocks.
Despite the news, what many investors think are bad companies — large cap stocks, in general — are undervalued. The price-earnings (P/E) ratio of the stocks that make up the Dow Jones Industrial Average is about 12, a little below the long-term average. The Standard & Poor’s 100, an index of the 100 largest stocks, also has a P/E ratio of 12. Stocks in the broader S&P 500 are trading at a below-average P/E ratio of 13.
Bears will argue that P/E ratios are distorted by unusual factors and are no longer reliable. They made these same arguments when P/E ratios were high by historic standards several years ago. It is best to ignore arguments and simply look at whether or not the P/E ratio is above or below the long-term average of 15.
With P/E ratios low, stock prices have been rising and could continue higher even as worries about the economy, government regulation and deficit spending mount. Investors should ignore the news and buy at times when the broad indexes are trading at a low P/E ratio as they are now.
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