Listen up everybody. Let me make a point that you need to understand. Warren Buffett is sitting on $40 Billion in cash right now. Why? Because for the best big investor in the world, this market has not gotten cheap enough to buy into in any serious way. That should tell you something. Please understand that it is fine to be in cash when you are not sure what to do. Buying into great companies when they are on sale is what Rule #1 is all about, but it's fine to sit in cash until you are sure you are getting both a wonderful business and a great price.
It is very important that you understand that Warren Buffett and me and people like us made our biggest gains when we invested when the market was at a PE of about 8. I started in the early 80's when the Dow hit 600. Just lucky. Buffett bought in big at times in the 50's, and then by the middle 60's was stepping back because the market was very expensive. Then he bought back in in the early '70s when the market PE got to 8, and again the early 80's -- and that is how you make a lot of money.
What does "a market PE of 8" mean?
It means that the big companies in the S&P 500 were selling for an average of 8 times their last year's earnings. Today the market PE is around 16. The average market PE for the last 100 years is about 15. The typical range is from 8 at the low to low 20's at the high, with the exception of bubbles and big crashes. What that means is that we will see a market PE of 8 eventually. It has now been about 25 years since the last one. We are quite due.
Here's a chart of the S&P 500 PE ratio lately vs. its historical average. You'll see what I mean when I say it can go down quite a lot, because it hasn't been below its historical average for many, many years. That day is coming soon.
So how does the market get to a PE of 8? It gets there in one of two ways.
The really hairy but good way (for us anyway) is that it crashes down to it quite suddenly. The most recent example was the crash in 2000-2002, except that that one only took the market PE from about 30 something down to about 18, where it rallied on the massive Fed rate cuts. As the Fed poured cash into the economy, businesses' earnings took off and fear declined and then went away.
We are seeing big rate cuts again and they may stave off the crash, but they can't stop the market from sliding sideways.
Which brings up the second way the market gets to an 8: The S&P 500 businesses are good businesses and, in this second scenario, they continue to grow their earnings, in which case their earnings are going up, but the price of the stock is staying the same -- because of fear on the part of fund managers who are very worried that the market is going to flop into the first scenario and crash.
Because of that fear, they are quite unwilling to take any long term positions in stock, and so they sell whenever the stocks they own make a little run up. This fear and the trading that follows it keep the market flat or headed down. And eventually we slide along until we get into single digit PEs. And then it's time to load up the truck.
I think if you guys are patient and hold onto your cash, and practice with paper money or just a little money, you are going to see some buying opportunities in the next couple of years that will blow your mind. A big clue, by the way, will be when Berkshire starts buying public stocks. And I'll be right here to tell you when that starts to happen.
Meanwhile, hold on to your cash and
Now Go play!