Viral Investing, Part II: What Should I Do Now?

“Profit from folly rather than participating in it. Be fearful when others are greedy. Be greedy when others are fearful. I prefer buying things. Otherwise, it’s a little like saving sex for your old age.” —Warren Buffett

“The true contrarian only buys when it makes him feel physically sick to press the buy key.” —James Mackintosh

I had a lot of response to last week’s post on “Viral Investing.” And no wonder—stocks have fallen faster this month than they did during the Global Financial Crisis or even during the Great Depression. Of the six worst trading days in the history of the S&P 500, two happened within the past two weeks.

On the other hand, Tuesday was the best day in the Dow since 1933. Go figure.

The responses to last week’s post were all over the place, including those who hazarded the guess that I had taken leave of my mind. However, the overriding question from readers was, “Okay, so what do I do now?”

People who asked that question tended to fall into one of three categories, as follows:

“I haven’t done anything except ride the market down, but now stocks represent a much smaller percentage of my overall portfolio. How do I get reinvested?”

“I got really nervous and sold a lot of my stocks and now stocks represent a much smaller percentage of my portfolio. Should I start buying or keep selling?”

“I was mainly in bonds and cash when the market rout started—thank goodness!—but I’m a long-term investor and need to get growth out of my portfolio.”

When thousands of people are reading your blog, it’s silly to think that one piece of advice will make sense for all of them. So what follows isn’t “advice” as much as it is a way of thinking about the question, “What do I do now?”

To get at an answer to that question, let’s start with how we think about stock market valuations. Although there are many ways to value broad markets, I’m going to use the price/earnings ratio because a) it’s simple, and b) we have a very long history of P/E ratios. (We have very good data going back to 1926, and less good data going back from there into the nineteenth century.)

A price/earnings ratio is simply the ratio of the price we pay for a stock divided by the company’s earnings. Let’s suppose that we bought one share of the stock of COVID, Inc. for $100 and that COVID’s earnings are $6.25/share. That’s a P/E of 16—which happens to be the long-term average for the Dow over the past 90 or so years.

We can calculate a P/E based on last year’s earnings or this year’s expected earnings. The beauty of the former (sometimes abbreviated TTM, for “trailing twelve months”) is that we know exactly what last year’s earnings were. Unfortunately, it’s this year’s investment returns we’re interested in, not last year’s.

The beauty of calculating P/Es based on a company’s future earnings guidance is that that’s when we will be invested. Of course, we don’t know exactly what this year’s earnings will be, but companies are pretty good at estimating forward-looking results, and when we are looking at larger companies (as in the Dow or S&P 500) there are also many analysts publishing earnings estimates.

Now that we know how markets tend to sell on average (a P/E of 16), let’s answer the questions posed above. We’ll begin by making the assumption that, to get back to your target equity allocation, you need to buy $100,000 worth of stocks at the current, reduced prices.

The safest approach is to assume that the COVID-19 Bear Market will be one of the worst, similar to 1973–74 and 2008–09, and that P/E ratios will, accordingly, drop to @ 10x or even slightly lower. That also means that the Bear could last two years before the market hits bottom and the stage is set for the next Bull Market.

As these words were being written, the P/E of the Dow was about 13x. Since the market peaked in February just short of 20x, and since our expectation is that P/Es could go to 10 or lower, we are already two-thirds of the way to the bottom. Time is running out on us!

Knowing all this, the rest is easy. We need to invest our $100,000 over 18 months, or $5,600/month. In down months we will want to invest a bit more and in up months a bit less. If, at the end of 18 months, the markets are still falling and we aren’t yet back to our target equity allocation, we will keep buying.

Piece of cake. Questions?

Q: Aren’t we just averaging down?

A: Yes. Our goal is to buy back in to the market at an average of 11x PE or so. That way, even if the market only recovers to its long-term norm of 16x (usually recoveries do much better, if only on momentum), we will make a lot of money.

Q: Why not just wait for the bottom and buy then?

A: Ha, ha, ha, ha, ha!

Q: But what if this time really is different, what if 228 years of history mean nothing in the face of COVID-19? The market could go to zero, the American economy could collapse and China could take over the world.

A#1: If that happens, losing money in your investment portfolio will be the least of your problems.

A#2: If you are really thinking that way, you might consider the possibility that what you need isn’t investment advice, but psychotherapy.