Buy low – how to spot the markets that have hit bottom

"Buy low, sell high." It's possibly the oldest adage in investing. And it's almost certainly one of the most infuriating mottos for a new investor to hear, as it's both obvious yet extremely unhelpful. Of course, you ideally want to sell an investment for more than you buy it for but this smug little saying doesn't tell you much about how to do it in practice.

However, the good news is that there is a reliable way to tell for a market as a whole, at least when prices are low. We're not saying that you can call the exact bottom or top of any market. But we will say that, as long as you're prepared to act like a long-term investor (keeping your money in a market for five years or more) rather than a short-term trader, then you should be able to pick up assets when they're cheap, so that they'll deliver better-than-average returns over the longer run. Below, we'll explain how, and pick out some cheap-looking markets for you to invest in.

The secret of mean reversion

At MoneyWeek, we're great believers in the concept of mean reversion'. It's based on two propositions. Firstly, that companies, and therefore broader markets, can be valued based on their fundamentals', such as their earnings, and dividend payouts. Secondly, that, while markets can sometimes become incredibly overvalued or undervalued compared to these fundamentals, the reality is that "it's never different this time".

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Therefore, when investors' mood-swings drive a market far above or below its fundamental value, it's a near-certainty that at some point it will revert to the mean'. Because no matter how good or bad things appear at the time, chances are that normality will assert itself.

A classic example of mean reversion in action in the stock market came with the technology bubble and burst at the turn of the century. As share prices hit stratospheric heights as judged by traditional valuation measures, pundits lined up to declare a new paradigm'.

The world had been changed forever by the internet, and so the old measures of value were no longer valid, or so it seemed. Of course, this turned out to be completely wrong. The bubble burst, and stocks fell further than almost anyone expected at the time. But the bust came as no surprise to Yale professor Robert Shiller.

In the 1990s, sceptical of the rampant rise in US stocks, Shiller and his colleague John Campbell investigated various valuation measures. By looking at US stockmarket data as far back as 1871, they found that one of the best predictors of future stockmarket returns was the cyclically adjusted price/earnings (CAPE) ratio now also known as the Shiller p/e'. When they published their findings in various papers at the turn of the century, US stocks were at unprecedented levels based on this measure. We all know what happened next.

The value of the Shiller p/e

A standard p/e ratio judges value by comparing the current market capitalisation of, in this case, a whole market, compared to one year's earnings (either the last 12 months for a historic p/e, or the next 12 for a forward p/e'). A low p/e indicates a market is cheap compared to its ability to generate earnings, and a high one indicates the opposite.

It's an extremely popular measure, and one most investors will have encountered before. The trouble is that it is flawed, mainly because it can be skewed by one-off cyclically high or low earnings. So, for example, when earnings (the e' in the equation) are high, it may look as though a company or market is cheap as judged by the p/e ratio.

But if the economy is about to fall off a cliff and drag corporate profits with it, this low p/e is clearly misleading. The opposite happens at the turn of the economic cycle: a company that looks expensive on a 12-month p/e basis might actually be cheap, because earnings are about to recover sharply.

This is where Shiller's modified version comes in. It's similar to the p/e, except that it compares the current market capitalisation of a market against a ten-year average for earnings. This smoothes out changes that are due to the differing stages of the economic cycle, and so gives a truer picture of just how cheap or expensive a market is at any given time.

Shiller demonstrated that this is the best way to predict future real (after-inflation) returns in the US market. When the Shiller p/e is high, anyone buying in is likely to be disappointed by their future returns. A low Shiller p/e, on the other hand, suggests a period of high real returns lies ahead (see the chart above).

The Shiller p/e has mainly been associated with the US stockmarket, but several studies have shown that it works on other markets too. Earlier this year, a paper called Value Matters: Predictability of Stock Index Returns, by Italian academics Natascia Angelini, Giacomo Bormetti, Stefano Marmi and Franco Nardini, demonstrated that the Shiller p/e worked in developed markets from France, to the Netherlands, to the UK.

The authors noted that, while there may be bubbles and crashes in the short and medium term, driven by investors chasing stocks up and fleeing when they go down, "for future long-term returns the valuation ratio remains a good predictor".

Even more recently, Joachim Klement, chief investment officer at investment consultancy Wellershoff & Partners, took the Shiller p/e and applied it far beyond US borders. He and his team investigated 35 different markets, this time including emerging markets. Even allowing for the fact that "in smaller developed countries or emerging markets inflation and growth dynamics may differ significantly from the US or the UK", he reckons it's a pretty good predictor of long-term equity returns in those markets too.

His approach is basically the same as Shiller's. He compares the real (inflation-adjusted) valuation of each stockmarket at various points in history, to its average real earnings over the previous decade (which gives the Shiller p/e). He then looks at how stockmarkets performed over the subsequent periods to decide whether a Shiller p/e can be relied on as a decent guide as to what real future returns will be for those markets. In short, Klement has tried to work out the ratio's accuracy in its function as a crystal ball.

Data in some markets can, of course, be a problem. For developed markets, reliable historic data stretches back for many decades. But even for a fairly advanced emerging economy like Chile, the data only stretches back far enough to calculate the Shiller p/e from 1998 onwards.

In turn, that means the study can only compare the result to four years of future earnings between 2008 and 2012, since you need ten years' worth of data from 1998 to 2008 to get a ten-year earnings average for the p/e calculation. So "the uncertainties around the results of our analysis is naturally bigger for emerging markets than for developed markets".

Another caveat is that, even where long-term data are available and reliable, the predictive value of the Shiller p/e is low for periods of less than five years but high for "longer investment horizons up to 240 months" (or 20 years). So this is no short-term trading tool. It's a way of uncovering markets where a patient investor can expect to reap decent returns. Don't be tempted to tie up money you may need in a hurry.

The markets to avoid

The good news for investors in stocks is that, on the whole, equities look attractive as an asset class. "Investors can expect to earn significant positive real returns over the long run with equity-market investments," says Klement. But you have to be picky about which country you invest in.

On top of that, it's worth having a large margin of safety. Why? Because, as Klement notes, big-picture' conditions for stockmarkets over the next five years could potentially be very unpleasant. Economic growth is likely to remain weak. Yet at the same time, interest rates can't go much lower.

In fact, they may even rise. Companies don't tend to thrive when growth is weak. Nor do they enjoy rising borrowing costs. So it's another good reason to err on the side of buying cheaper markets, which are more likely to have priced in harsh conditions.

Overall, developed markets look cheaper than emerging markets, reckons Klement. However, there's quite a wide range within those categories. On the emerging-market side, perhaps surprisingly, Indonesia has been selected as one of the least promising markets.

The country's stocks have shot up as investors disillusioned with the Brics (Brazil, Russia, India and China) have moved on to the next big thing. But as a result, it now looks rather expensive and may even end up delivering "negative real returns over the next five years". Elsewhere, more established emerging-market options such as India and China are priced to deliver "only average return prospects".

On the developed-market side, meanwhile, the US and Canada both look expensive. Indeed, the US has "the lowest expected real returns of all developed countries". That makes sense. The S&P 500 is trading on a Shiller p/e of nearly 22, well above its historical average.

and the ones to buy

So what are the best bets for investors? Within emerging markets, Brazil is among the most promising options. However, we'd be slightly wary of buying into Brazil just now, mainly because at around 12.3, the Shiller p/e isn't quite at mega-cheap' levels yet. Given Brazil's exposure to the bursting commodity bubble, and its own consumer-credit bubble, we suspect there'll be better opportunities to buy Brazil in the future.

A better bet lies much closer to home: Europe. "European countries promise very high real returns over the coming years that should be significantly higher than historic averages." The massive cloud hanging over European stocks, of course, is, what will happen to the euro? European Central Bank boss Mario Draghi has promised to do whatever it takes' to save the euro, but there are plenty of potential hurdles in his way.

However, it may not matter what happens to the euro. Ben Inker of US value-investing group GMO points out that, according to their forecasts, European stocks (excluding financials) should only be down 13% (in real, inflation-adjusted terms) from their 2007 highs. Instead, they have lost something closer to a third of their value.

In effect, says Inker, "current valuations of non-financial stocks in the eurozone broadly discount an ugly endgame for the region. If something less bad than that occurs, the stocks are at least mildly cheap."

Inker acknowledges that "mildly cheap" is hardly "a table-pounding endorsement", but at the same time, GMO is arguably one of the most conservative (dare we say sensible') asset managers around. So if they're willing to make a "significant bet" on eurozone equities, we'd say that's a good sign.

You don't have to pile in all at once there will no doubt be a lot of volatility in the months ahead but we think now would be a good time to start "averaging in" (ie, regularly investing a set amount) into the eurozone. We look at how below.

The best bets in the eurozone

Of all the eurozone markets, Greece is unsurprisingly the cheapest. On a Shiller p/e of less than four, the market potentially offers real returns of more than "100% over the next five years", says Klement. Trouble is, Greece also has by far the highest "standard error in the forecast" ie, there's a greater risk of the forecast being wrong.

It's certainly tempting, but make no mistake, this is a real high-risk option. If any country is going to get kicked out of the eurozone and revert to its old currency, it's Greece. If you do fancy taking a punt on it (and a punt is what it is), then you can invest via the Lyxor ETF FTSE Athex 20 (Paris: GRE).

However, while we think buying Greece now still qualifies as an out-and-out gamble, other parts of Europe look like more of a calculated risk that could really pay off in the long run. Klement notes that even core' European countries such as Finland, France and Germany "offer attractive long-term return possibilities".

And while the paper doesn't cover Spanish and Italian markets, Klement told MoneyWeek that Wellershoff & Partners is keen on both of those markets. Favoured Italian stocks include oil and gas group ENI (Milan: ENI) and luxury goods company Tod's SpA (Milan: TOD).

In the Spanish market, they like food technology group Viscofan (Madrid: VIS) and retailer Inditex (Madrid: ITX). If you'd rather track these markets as a whole an easier way for British investors to get diversified exposure then you can buy an exchange-traded fund (ETF). You can track the Italian stockmarket via the iShares FTSE MIB (LSE: IMIB), for example.

If you'd rather stick to the core eurozone markets, then there are trackers available for the German and French indices too (options include the iShares DAX (Germany: DAXEX), which tracks the German index, while the Lyxor ETF CAC 40 (France: CAC) does the same for France).

But if you want exposure to the whole eurozone, you might be better off with a wider-ranging fund. Several European investment trusts trade at attractive-looking discounts. We'd be tempted to opt for those focusing on smaller companies, partly because they aren't dominated by the usual big company names like Nestl, and partly because smaller companies are likely to do better from any rebound inspired by European money-printing.

The Montanaro European Smaller Companies Trust (LSE: MTE) has soundly beaten its benchmark since launching in 2006. It currently trades at a 15% discount to its net asset value (that is, the value of the shares in its portfolio), compared to an average discount of 10% or so over the past five years.

The trust's holdings are heavily weighted towards the safer' eurozone countries, such as Germany, Austria and Finland, as well as non-eurozone nations such as Sweden and Norway. However, Spain accounts for 4% of assets while spicier holdings include Greek commercial fridge manufacturer Frigoglass.

Another option is the JP Morgan European Smaller Companies (LSE: JESC). Its track record is not quite as good as that of Montanaro (according to Association of Investment Companies figures), but it does have a higher weighting towards peripheral eurozone countries such as Italy (12% of assets) and Spain (5%). It's on a discount of 14%.

Of course, there is potential currency risk with these investments: you are buying euro-denominated assets in pounds sterling. This is a concern. There's a more than negligible chance that the euro will break up. Even if it doesn't, the euro could end up being a far weaker currency, depending on the actions of the European Central Bank.

That said, we think that, in the long run, the cheap price of the underlying assets should more than make up for any loss in the currency. However, that's why it's important to ensure you make these investments for the long run they promise to be volatile, so if you have to get your money out at short notice, you might end up with a big capital loss.

As GMO's Inker puts it: "Owning the eurozone is undoubtedly a nerve-racking activity at the moment." But then, you don't get to pick up assets on the cheap without steeling yourself for a few stressful moments.