I have followed a thought process (and here) in terms of looking at market valuation in terms of PE bands. So if the market is below a PE of 12 or below, it likely to be undervalued (odds are favorable for an investor – to the tune of 7:1 or better). At the same time if the PE is more than 20, the market is moving towards overvaluation (unless there is a recession in the economy and earnings are really depressed) and the odds are against an investor (1:3 or worse). However, I found it difficult to form a firm opinion between the above PE levels. The market is typically between these two levels 60-70 % of times and as result I am inactive and not buying an ETF or Index funds. However if the market drops below a PE of 12 or below, I usually start buying actively and if the market goes above a PE of 20, I start a slow liquidation.
I don’t use the above approach to individual stocks, where it is possible for me to have a better idea on whether the stock is over or undervalued (provided the stock is in my circle of competence).
I was pleasently surprised to find the following reply from Warren buffett in his Q&A at Wharton.
I would suggest downloading the Q&A (pdf) and going through the complete transcript for other nuggets of wisdom from buffett.
Q: You made an argument for 7% returns over the next decade in Fortune. Given that (1) profit margins are at least 30% above historical averages, (2) the ratio of prices/GDP is at least 25% above historical averages, and (3) interest rates are ~25% below historical averages, assuming mean reversion, wouldn’t one conclude that while economic earnings growth plus dividends may be 7%, that we are at an unsustainable valuation plateau?
A: We are near the high-end of the valuation band, but not really at an extreme. I have commented on the market 4 or 5 times in Forbes interviews previously (1969, 1974, 1981, and 1977 in Fortune). Most of you can say if something is overvalued or undervalued, you can spot the occasional extreme cases.
There is a big band of valuation and the idea is to calibrate extremes. When I look at a business, I look for people with passion. I can recognize a 98 or a 6, not a 63 (emphasis mine). This rule is good enough in life and investment. You refer to my 2001 article, but returns have not exceeded 7%, so I guess that this is not that precise of a band.