Don't Let 'Sticker Shock' Spook You Out of Stocks

Editor's note: Today, we're sharing an essay from the newest member of our team, Sean Michael Cummings. His background isn't the typical Wall Street fare, but he's got a knack for digging deep and seeing what the crowd is missing in a story.

Sean started just last month, but he's already proving to be a valuable addition. Below, he shares a piece of research that few would guess is true – but with more than half a century of data on his side, it's crucial to understand today. Check it out...


The story of 2021 is the rising price of everything... And stocks, up 26% this year, are no exception.

The S&P 500's price-to-earnings (P/E) ratio has been expensive for years. And while it's slightly down from its highs recently, the ratio has still been in the top 10% of its most expensive readings since July.

In other words, it's a difficult time to be an investor.

The conventional wisdom, "buy low, sell high," tells us to buy when stocks are cheap... But that hasn't been an option this year.

These current valuations might cause a little sticker shock... But I'm here to tell you that stocks are still worth your attention.

That's because there's another key factor at work in today's market. And the crazy thing is... when this factor says "buy," you stand to make gains even when the market is at its priciest.

Let me explain...

I'm not here to knock value investing. The conventional wisdom does hold true...

You make more money buying stocks when they're cheap than when they're expensive.

Specifically, buying stocks when they're in the bottom 40% of "cheapness" leads to outperformance. This strategy led to historical gains of about 12% a year, versus the market's typical 8% a year.

Buying stocks in the top 10% of expensive markets still led to gains over the next year... but with a typical annual return of just 1%.

So, value does work. But history shows us that you can still capture consistent upside even if stocks are expensive... as long as another measure is in your favor.

In markets like today, we need to focus less on valuation... and instead, buy based on trend.

This may seem to contradict "buy low, sell high." But when stocks trend upward, they tend to keep that momentum going. An upward trend will lead to gains no matter how expensive the market gets, based on history.

We can see this easily if we split the market into four different states, based on value and momentum since 1954...

First, we'll say stocks trading below the median historic P/E are "cheap." Stocks trading above it are "expensive."

Then, we can use the 10-month moving average to find the simple trend. If stocks are above that level, they're in an uptrend. If they're below it, they're in a downtrend. (For more on moving averages, click here.)

You end up with four potential market conditions. It looks something that looks like this...

Knowing what we know about value – that it really does work – the "cheap" squares do what you'd expect them to do. If you buy when the market is a bargain, you can expect your investment to grow.

But you can make money in an expensive market, too... as long as the trend is on your side.

You can see it clearly when we rank these quadrants by profitability. Value is important. But sticking with the trend is an even surer way to make money. Check it out...

These numbers are simple. Cheap stocks performed well, as expected. They gained 4% in a downtrend and 15% in an uptrend.

But notice that lower-right quadrant? It shows us the power of buying the trend...

Expensive, upward-trending stocks grew by 6% – outperforming cheap stocks in a downtrend.

That means going long when stocks are expensive is fine as long as they're in an uptrend. In fact, buying these stocks is the second-most profitable thing you can do!

What does this mean for today? Well, stocks are undeniably expensive right now. But the uptrend is in place... And that's all you really need to get those gains.

Don't get sticker shock from today's expensive market. It's still a great time to be long.

Good investing,

Sean Michael Cummings

Further Reading

"Jaw-dropping valuations are a classic hallmark of a Melt Up," Chris Igou writes. You might be tempted to sell your stocks and hold cash until a better deal comes along. But that could mean missing out on a lot of profits... Read more here: You Shouldn't Stress About Sky-High Valuations.

"Most investors see new highs and get caught up in strong emotions," Brett Eversole writes. But strong emotions can often be a contrarian indicator. And that's exactly what happened in stocks recently... Learn more here: Don't Bet Against Stocks at New Highs.

Market Notes
THIS RENTAL-HOME GIANT IS HITTING NEW HIGHS

Today, we’re highlighting a company that’s thriving as U.S. housing booms…

Regular readers know one of the easiest ways to play the housing market is through real estate investment trusts (REITs). These companies often handle the “landlord” duties such as collecting rent, making repairs, and more. Most important, they are required to pay out 90% of their income to shareholders. Today’s company is a perfect example of this type of business…

Invitation Homes (INVH) is a $25 billion REIT. It rents out well-maintained homes in in-demand neighborhoods, primarily in Florida and the Western U.S. And it has nearly 80,000 single-family properties across the country. With a shortage of homes in the U.S. and housing demand booming during the pandemic, Invitation Homes has been benefiting… In the third quarter, the company posted revenue of $510 million – up 11% year over year. And funds from operations – a measure of cash flow – rose 27% year over year.

As you can see in today’s chart, INVH is performing well. Share prices have roughly doubled over the last three years… And they recently hit a fresh all-time high. As long as the housing market remains strong, so should this company…