How to time market peaks and troughs

If you had invested £1,000 in a FTSE 100 tracker fund in early 1998, its capital value would be virtually unchanged today. Yes, you would have collected some dividends, but you may have been better off investing in bonds, or even cash. You'd certainly have slept more soundly by avoiding all that volatility. The fact is that the old adage of buy and hold' as the road to stockmarket riches has been a myth for many investors. Over the last decade, the market has traded in ranges reflecting investor optimism and pessimism at any given moment. But it has failed to make new highs.

So what's changed? From the early 1980s until 2000, stockmarkets were supported by a mix of earnings growth, falling long-term interest rates and expanding p/e multiples. So profits were growing, borrowing was getting cheaper, and the amount that investors were willing to pay for a given level of earnings kept rising. As a result, anyone who bought a basket of stocks and held them throughout that period probably did well.

Today, with interest rates at historically low levels, inflation rising and economies weak, the reverse scenario falling profits and rising borrowing costs is very possible, making it harder to profit from stocks. We're not saying that you can't make money in sideways' markets you just need to work harder at it. This means that you attempt to sell into market rallies and buy at times of pessimism. While it is difficult to time peaks and troughs, there are some tips on how to go about it.

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1. Focus on quality stocks, not markets

Buying a tracker fund or a unit trust that's benchmarked to an index is probably not the best strategy. Contrary to popular belief, tracking an index doesn't reduce risk, as large portions of indices can be concentrated in specific firms or sectors. (The FTSE 100 is a good example.) A concentrated portfolio of ten to 12 good-quality firms across different industries can yield superior returns while diversifying risks to acceptable levels.

2. Develop your valuation skills

This is the linchpin of successful stock investing in volatile markets. What is important is that you remain disciplined, choose a valuation metric that you are comfortable with and stick with it. For example, you may decide to value stocks on the basis of their p/e ratios and note that a particular company trades in a range between 11 times and 15 times. Providing this company meets the quality criteria, you would attempt to buy it at 11 times and sell at 15 times.

3. Reverse-engineering share prices

The investor always has two pieces of key information a company's latest financial report and its share price. Along with the required rate of return, these can tell you a lot about what the market is implying about a company's future prospects. For stable dividend-paying stocks (eg, utilities, tobacco stocks), an estimate of a company's value can be derived from the Gordon Growth Model where:

Price = Dps1/(r-g)

Here, Dps1 = expected dividends one year from now; r = the investor's required rate of return; g = the expected ongoing dividend growth rate. So if next year's dividend is expected to be 10p a share, the investor requires a return of 10%, and expected growth is 5%, the implied share price is 200p.

By using simple algebra, the implied rate of growth from a share price is simply the required return minus the prospective dividend yield. If the implied rate of growth is low, then the stock may be at an attractive buying level. To get the most value from these approaches you have to estimate implied growth rates over a reasonable period of time, such as ten years, and look at how these have changed over time. Remember, this strategy only works if the market expectations currently baked into the share price are wrong. Shares are sometimes cheap for a reason.

4. Don't be afraid to hold cash

Unlike many professional investors you don't have to be fully invested in stocks. If you don't see any shares that look good value you don't have to own any. Holding cash balances or bonds gives you the opportunity to exploit attractive valuations when the time is right. This is far better than seeing a fully-invested portfolio lose value in a bear market.

5. Build a watch list

Most of your time shouldn't be spent trading, but researching quality stocks, so that you can be in a position to buy them when the valuation is right. Remember: a good firm is only a good stock if bought at the right price.

Is Tesco a buy?

Tesco is an interesting example of a stock that is near the bottom of its valuation range. Here we have calculated its average share price (daily share price data is freely available from financial websites) for the last ten years and divided it by the diluted earnings per share (from its annual report) for the previous year to create its historic trailing p/e ratio range. Now, all valuation methodologies have their pros and cons, but on this basis Tesco has only been cheaper once in the last ten years than it is today. Are Tesco shares a buy? Maybe, maybe not. Tesco faces a challenging UK market, but is growing nicely overseas, while the City still expects earnings and dividends to increase.