Why You're Crazy To Buy An Index Fund Right Now

¹²Why You're Crazy To Buy An Index Fund Right Now

By Dan Ferris | 18 March 2010

I doubt you wake up every morning saying, "Gee, if only someone would pay me 4.37% on my life savings." Nobody does. Getting paid 4.37% isn't nearly enough. But that's what the stock market is offering you right now. And plenty of people are buying. [[And that was a month ago!: normxxx]]

In fact, I have three ways to gauge value in the stock market and none of them get me excited enough to buy stocks right now. Let's start with that 4.37%. The Wilshire 5000 is an index of U.S. stocks. It holds everything from huge companies like ExxonMobil all the way down to stocks of less than $1 million in market cap. It's the broadest measure of American stock prices around.

Today, the Wilshire 5000 is selling for about 22.9 times earnings. This is expensive. To calculate just how expensive, divide 100 by the price-to-earnings level. At 22.9 times earnings, stocks have an "earnings yield" of 4.37%. Think of it this way: If corporate earnings don't shrink at all below the current level, the stock market is offering to pay you about 4.37% a year on your money. That's pathetic.

(For that matter, so is the 4.67% government bonds are offering to pay you. And so is the yield on corporate bonds. Moody's triple-A bond yield forecast for the month of March is 5.53%, or about 18.1 times pretax earnings.)

We're in a "sideways" market right now. That's when the market ratchets sharply up and down for many years, gradually getting cheaper, on average [[when inflation adjusted: normxxx]]. Sideways markets historically have been a good deal at earnings yields of 9%-14%. That's what I'll look for before I say stocks as a group are cheap.

Aside from earnings yields, the second number I use to gauge value in the market— cash dividend yields— offers investors nothing to look forward to. The Wilshire 5000's cash dividend yield is still under 1.9%. At that level, you'll double your money every 52 years. A knowledgeable, rich investor only gets excited about the broad market when cash dividend yields are up around 5%?-7%.

A third way to look at stocks is to compare their total market value to the size of the U.S. economy. This value gauge is a favorite of superinvestor Warren Buffett. As of the latest report by the Bureau of Economic Analysis, the United States' current dollar GDP is $14.3 trillion. The entire market cap of the Wilshire 5000 is approximately $13.3 trillion. So stocks are around 93% of GDP.

Stocks aren't really cheap until they're less than 80% of GDP. And they've been as cheap as 50% of GDP. Altogether, that's (1) low earnings yields on businesses, (2) low cash dividend yields for holding stocks, and (3) a stock market that purports to be very nearly as valuable as the entire U.S. economy. The stock market is not compensating you adequately for the risk it's asking you to take. It's not offering enough earnings, enough dividends, or enough value.

You should only invest when you can get terrific value for your money. And buying a broad swath of the market right now— as you do when you purchase an index fund— isn't providing you with great value for your money. Not even close.

That's not to say there are absolutely zero stocks cheap enough, safe enough, and just plain good enough to buy today. There are [[but generally only if you are willing to expand your investment horizon out beyond the short term: normxxx]]. Microsoft is a great example of a stock that's safe and cheap enough to buy right now. Microsoft is the single company rated triple-A by the only credit ratings agency I trust, Egan-Jones Ratings. (Egan-Jones isn't paid by securities issuers. It's paid by investors who use its ratings, like you and me.)

Microsoft is also very cheap— cheap enough and rich enough to pay the interest on enough bonds to buy all its outstanding shares. In short, it makes so much cash it could afford to buy itself. It's selling today for about 12-13 times the amount of free cash flow I expect it to generate in the fiscal year ended June 30, 2010. (See also Historical Earnings Valuation and Cashflow, Free Cashflow, and Proforma Forecasting.) In other words, this blue-chip World Dominator is much cheaper than any broad index fund you'd buy today.

And if you think you can't make big money buying big-cap stocks like Microsoft, think again. I recommended Intel about a year ago, and it's up 50% since. Microsoft is as cheap today as Intel was a year ago.

Good investing,

Dan Ferris