Should we wait for a stock market bottom? Not always. Sometimes it pays to invest early.
I used the Stock Returns Predictor. [See the Stock Returns button on the left.] I examined P/E10=12 and P/E10=8.
Today’s stock market is close to P/E10=12. According to the Stock Returns Predictor, the most likely real return at Year 10 is 8.15%. The most likely real return at Year 20 is 7.59%.
If we bottom at P/E10=8, which is 50%-50%, the most likely real return at Year 10 would be 14.51%. The most likely real return at Year 20 would be 12.11%.
I compare investing a full 10 or 20 years at the P/E10=12 return versus a shorter time period assuming the P/E10=8 return.
Ten years at the P/E10=12 return of 8.15% is a growth factor of (1.0815)^10=2.19. Similarly, over twenty years, the cumulative growth is (1.0759)^20=4.32.
It takes 5.78 years at the P/E10=8 return to grow as high as ten years at P/E10=12. This is Year 4.22 from the beginning.
It takes 12.80 years at the P/E10=8 return to grow as high as twenty years at P/E10=12. This is 7.20 years from the beginning.
These are the crossover points.
You can wait 4.22 years for a bottom before losing out at Year 10. You can wait 7.20 years for a bottom before losing out at Year 20.
If you invest $1000 when P/E10=12, it will grow to $2190 (plus inflation) at Year 10 and $4320 (plus inflation) at Year 20.
If you only have to wait 3 years for P/E10=8, the balance at Year 10 will be $2580 (plus inflation). If you must wait for 5 years before P/E10=8, the balance at Year 10 will be $1970 (plus inflation).
In terms of Year 20, if you only have to wait 5 years for P/E10=8, your portfolio balance will grow to $5550 (plus inflation). If you must wait for 10 years before P/E10=8, your portfolio balance at Year 20 will only be $3140 (plus inflation).
We can gain important insights from these simple calculations.
We do not know for sure that P/E10 will fall as far as 8. We could have reached a bottom already. It helps to be invested at least a little at the moment.
Waiting can pay off, but we do know how long it will take to reach a bottom. It makes sense to invest a little bit more each year as time progresses just to make sure that we do not miss out. After all, we can be ahead by investing early if the bottom is several years off.
Depending upon your own time frame, you should invest heavily into stocks by Year 4 to Year 7, assuming that valuations remain low.
John Walter Russell
March 14, 2009