'Buy low' means never buying anything

"Buy low, sell high" may be the least helpful piece of investment advice ever given.

On the surface, it looks wise beyond reproach. The message is pithy and direct, dispensing with the non-essentials and stating the point of the whole endeavour in words of one syllable.

What the slogan sorely lacks is any grounding in reality.

Those four little words convey no sense of how difficult it is for most investors to put them into practice.

Uncounted hordes of people who try to heed the advice never buy at all. Or they end up buying later at a much higher price after waiting fruitlessly for a stock, mutual fund or other security to come down to some vaguely imagined "bargain" level.

Turns out that low and high are the ultimate in relative terms, much harder to define than they sound.

For a practical demonstration, take a look at the state of the stock market. Note that at mid-2006, several of the broad market indices were actually lower than six years before.

The Standard & Poor's 500 Index showed a total return, including dividends, of minus 3.7 per cent since the end of June 2000. The Nasdaq Composite Index was down 44 per cent, having declined over that stretch at a rate averaging 9.1 per cent a year.

When last I looked at the S&P 500 price-to-earnings ratio, as calculated by Bloomberg, it stood at less than 17 times the most recent 12 months' earnings. It has been cut in half from a high of almost 35-to-1 four years ago.

Turn the P/E ratio upside down, putting the earnings on top and the share price on the bottom, and you get something called the earnings yield. That makes it easier to compare with the interest yield one can get from bonds, which compete with stocks for investors' favour.

In rough terms, the earnings yield of the S&P 500 has risen to six from three since 2002. Over that same stretch, the yield of the 10-year Treasury note has increased to about 5 per cent from about 4.5 per cent. So stocks, which were 33 per cent less attractive than bonds by this measure four years ago, are now 20 per cent more attractive than bonds.

Present these numbers to many investors nowadays, and you will be met with a shrug. The only reason P/Es look so attractive now, people will tell you, is that earnings have climbed to a cyclical peak from which they will soon descend.

Haven't I seen the latest headlines from the Middle East, Korea, and other turbulent locales all over the globe? Did I miss the news that inflation was rising and threatening to accelerate some more? Has it escaped my notice that soaring petrol prices and a faltering real estate market have put US consumers in a terrible bind?

When these things really begin to take their toll on the world economy, the pessimists assure us, today's stock prices may not appear cheap at all. And you know what? They might be right.

There we see the hang-up: Chances to buy low in the stock market are always accompanied by compelling explanations why prices might go lower still.

That's true in other markets as well; think back to the early 1980s in the bond market. For most of August, September and October 1981, you could have locked up an annual yield of 14 per cent to 15 per cent by simply buying a 30-year Treasury bond. This proved to be one of the greatest bargains a generation of investors would ever see. Recall also that it took a daredevil to buy those bonds.

Everyone knew that runaway inflation was going to turn their yields into fool's gold by wrecking the money's purchasing power.

In the 1970s and early 1980s, P/E ratios also got wildly skewed. The ratio of the S&P 500 hovered around 8-to-1, or half of today's level. If we are going back to a multiple of eight again, we've got much more pain to suffer through.

The good news is, that's highly improbable. The earnings yield that a P/E of eight represents is 12.5 per cent, which made sense when compared with bond yields of 14 to 15 per cent.

It makes far less sense now. Today's conditions aren't nearly so extreme. But it's still as hard as it always was to buy low, sell high.

- BLOOMBERG