By Professor Ricardo “Rick” Ulivi, Ph.D.

Year to date the stock market is down about 10%, depending on the day you take the measurement. In financial terminology, that’s a correction. Another 10% drop, and it will be considered a bear market.

A 10% drop can be ignored; you can argue that it is a temporary situation, and the market will bounce back. However, if you are retired or close to retirement, a 10% drop can mean a loss of $50,000 on a half a million dollar portfolio, or a $100,000 loss on a larger portfolio. That’s serious money; you can’t just ignore it. What should you do now? Sell and aim to buy back later, or ride it out? The answer depends on your strategy. Let’s review some theory and courses of action.

What’s causing the market’s drop?

Is it a slowing of the economy and a prediction that we are heading into a recession? In this case, it makes sense that the market is losing value, but I don’t think this is the reason. That’s because the economy is growing–slowly, but it’s growing. With interest rates and gas prices low, inflation non-existent, and employment growth improving, I don’t believe we are headed toward a recession. So, what’s causing the price drop?

The secret to buy low, sell high? Valuation

I believe the drop in prices has to do with valuation, or more specifically with stock prices currently being overvalued. Let me explain.

The fundamental way to make money is simple: you buy low and sell high. For example, buy something for $20 and sell it later for $30, and you’ve made yourself a cool $10 or 50% rate of return on the original investment. What’s the hard part? Deciding whether the price is high or the price is low. What’s involved in figuring this out? It has to do with something called the price-earnings ratio. Let me explain in simple terms. A share of common stock sells today for the equivalent of the next 10 or 15 years of profits. For example, if profits are expected to be $1 per year for each of the next 15 years, a stock would sell for $15. Got it?

However, if people get a bit too excited, they might start thinking that this company’s profits will actually be, let’s say $1.20 per year. In this case, the stock will sell for $18.

What is the true price for this stock? Is it $15 or $18? Could it be $13? If you pay $15, but profits later reveal themselves to be $0.87 per year, you will have overpaid and lost money. However, if profits actually turn out to be $1.20 per year, then what you bought for $15 you will be able to sell later for $18. You bought low, and sold high. See how easy it is to make money and avoid losing!!!! All you have to do is accurately predict what future profits will be.

Is the stock market overvalued?

I believe the current drop in prices has to do with over valuation. That is, in the last few years market participants have been too optimistic about future profits, and they have bid stock prices up more than they should have. For example, the US economy has been growing at an average rate of 2.5% for the last 5 years, while the average stock price has been going up 12.5% per year. Do you see the discrepancy?

At some point, either the economy has to start growing faster to catch up with stock prices, or stock prices have to come down to more closely reflect the growth of the economy. While the economy is growing, I don’t think it will speed up enough to produce the type of profits the stock market is expecting. Therefore, stock prices should drop to reflect a more realistic intrinsic value. If my forecast is correct, what should you do now?

Here’s my recommendation: Sell now and buy back later

The math behind my recommendation is simple. For example, suppose you own one share of a stock whose market price is $10. Let’s predict that it will drop to $8 and eventually return to $10. Sell it now, keep the $10 in cash, and buy back the stock later at $8. Here’s the magic, now you will be able to buy not one share but 1.25 shares with your $10. When the stock goes back up to $10 per share, you will own a portfolio of $12.50, which is far more than the $10 you would have if you would have ridden this out.

Follow my advice. Sell now and buy back later. To discuss this further, call me at 1-714-771-6000 or just email me.