How Important is Market PE?; Applying Tools to the Market; and Where to Put Cash

Three interesting comments were posted to the blog over the past week, and I answered them tonight. I'm re-posting them here so you can all see the answers.

1.  From Dom, re: "Predicting the Market":

If we can use the tools to see what the big boys are doing and predict stock prices, why can't we do that with the stock market? If we know that the PE of the market is generally 10, shouldn't we be able to buy when it is less and we have 3 arrows? Also, should we continue to use a PE of 10 or should we consider bumping it up like we do for our future sticker prices?

Basically, if we know that a good company is going to grow at its historical rate, couldn't we also say that the markets will grow at their historical rates? If so, couldn't we use the tools to predict them the same way we predict stock prices?

My response:

You make a good point.  First, though, the market averages a PE of about 15, not 10.  A market PE of 10 is low.  The problem with relying on a market PE is the same problem we have relying on a PE for a business.  I wish it was that simple but it isn't.  PE's reflect expectations of growth.  Thus a company with a high PE might be a lot cheaper in the long run than one with a low PE, depending on what you pay for it.  When we look at the whole market, all we can do is make the reasonable assumption that in the long run the market is going to do well. 

By 'long run' I mean over the next 20-30 years.  America is competitive.  Our businesses are competitive with the world, so things should hold up well in the long run.  That's our general philosophy.

So when I say that you can load up the truck when the market PE is low -- like under 10 -- I only mean that in the most general sense.  You still have to determine that the business is durable, that management is wonderful and you understand the business well enough to buy it in the first place... and then that it has a big margin of safety. 

In effect, the price of the entire market is only relevant in the sense that it is more likely that great businesses will be on sale in a market with a PE of 10 than in one with a PE of 40.

So don't take any shortcuts and don't rely too much on the 'market' price.

2. From hurdler52, on the same post:

My question has to do with the tools (tech. indicators). Should we apply them to the market before applying them to the individual companies, or does it even matter?

My response:

I think it makes a lot of sense for a small investor to watch the market as a whole with market indicators like the SPY, DIA & QQQQ and others.  There is an old saying that 'the trend is your friend'. It is very difficult to time the market and do well, so we don't really try to do that.  But we do look for the general trend and try not to buy companies when the trend in the whole market is down. 

It also pays to look at the trend in the industry that you are buying into.  Again, it's just an indicator and not the final arbiter, but if the market trend is down and the industry trend is down, it is very hard for a good business to make price headway into that strong of an emotional headwind. 

Essentially those down trends are created by the Big Guys, and it's Big Guy money being poured into your business that makes it go up in price.  If they aren't doing that, the price at best isn't going anywhere.  So yes, watch the big indexes to get an idea of the general trend.  That's the sort of thing I'm looking at when I tell Maria Bartiromo that when the big guys are leaving the market, it's time for the little guys to leave, too.

3. From Nozzy, re: "Cash is Good Until You Are Sure":

I understand the old saying, "Cash is King". I am a new Rule #1 investor, and am currently working on my list of wonderful companies. In the meantime, when staying in cash, where would be the best place to put it? I have read a few posts on this topic, but would like a little more input. I appreciate any and all of your help. This is a great website and blog. I have learned a lot just by reading all of the posts. Thanks to Phil and all Rule #1 investors.

My response:

Cash can sit anyplace safe that's paying some sort of interest.  An insured brokerage account is the most convenient if you have enough of it that the broker is willing to pay a money market rate.   

BusinessWeek says the following:

"Some brokers have a tiered interest rate system that depends on your account size. On balances of $10,000 or more, for example, Interactive Brokers pays 4.8%. Accounts with less than $10,000 earn nothing. At Scottrade, $1 million accounts get a 4.3% yield, while those with under $1,000 earn only 1.8%.  Whichever broker you choose, ask about how cash is treated. At Muriel Siebert, T. Rowe Price, and Vanguard, for instance, cash automatically goes to a money market fund. At others, such as Schwab, E*Trade, and TD Ameritrade, you need to specifically instruct the firm to sweep your cash into a money market fund. Otherwise it will sit in a cash account, with the yield determined by the firm, not the market. Those yields may be only around 1%." 

Now go play.