Stock Investing 101

The the time of writing this, the middle of January 2010 the price to earnings ratio of the S&P 500 is around 17. This is about average for the index.

Before the big run up that the major stock market indexes saw starting around March of 2009 the price to earnings ratio of the S&P was very low, around 11-12. Which means that stocks in the index were obviously undervalued.

It is generally a good idea to invest when the price to earnings ratio of the S&P 500 index is in the low double digits between 10-15 and to be weary of investing when the price to earnings ratio reaches 20 and beyond. It is a great way to discipline yourself and to buy low and sell high.

This ratio is flawed however for a few reasons. The first reason is that a few companies or a sector of companies can completely distort the data. The S&P 500 is almost 20% financial, meaning that the banks that have taken big loses because of faulty practices have distorted the data. If the financial sector was removed from the S&P index then the price to earnings ratio would likely drop significantly. The ratio is also flawed because it looks backward instead of forward. It takes the earnings of companies for the last 4 quarters instead of forecasting the earnings for companies over the next 4 quarters. You always want to stay ahead of the game when you are investing.