Tuesday, June 06, 2006

Reversion to the mean, and other value investment techniques

I'm a value investor according to most definitions, meaning that I look at the fundamentals of a company or market and not at the trends. I've considered buying into Apple and AMD some time ago, and my money would have more than doubled by now. But much of the activity that has boosted both stocks is based on speculation moreso than the fundamentals of what the companies can deliver; following the herd can be exciting and profitable if you know exactly when to get out, but I'm not a big gambler like that. In the past month they've both lost 17%. And I know so many people that lost money in 2000 that are much smarter than I that I feel it's not sensible for me to take huge risks.

So it's with this in mind that I'd like to point out that we are returning to much more reasonable P/E ratios, meaning that companies are more affordable for what they can actually deliver. Their stock price (P) is dropping due to market fears, while most companies have been reporting better earnings (E), making stocks more affordable for their value. This 50-year trend graph shows the P/E along with highlighted regions of Bull (aggressive) markets. The upcoming "reversion to the mean" is an indicator of stability, where the market reflects and regroups at a safe point while determining where the next bull market will take off. But heed the warning that market trends overshoot in both directions, which is why I still believe we're in for a soft spot until winter or spring, and we're not yet at a good buying opportunity.

My contrarian posts share my feelings about when to get out of the market, since it can be very hard to walk away from a "hot table". But I am also a contrarian in the sense that I don't trust most trends (I still wore 80s short-shorts in 1990 when jams became popular). Follow the fundamentals and you can not only get out of a volatile trend (with its possible but risky profitability), and then it's much easier to get back in to the market when it softens since you avoided getting burned.

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