New lessons from the crash

(Money Magazine) -- Every major market crash is considered a teachable moment. And the lesson for investors invariably centers on the risk of overreacting to the news, in this case by attempting to flee equities when they're down. Countless studies have shown that this type of market timing will cost you dearly.

Normally the antidote for this behavior is simple: Ignore the noise and stick to an asset-allocation strategy that is suited for your age, goals and tolerance for risk. And then rebalance your portfolio back to the original mix annually.

But this is not what many financial advisers are calling for this time. In fact, they say it may be well worth your while to pay close attention to what's going on in the market today.

That's because this crash has done something no other bear market in decades has managed to accomplish: It has made stocks genuinely cheap. In fact, the price/earnings ratio on the Standard & Poor's 500 has sunk below its historical average of 16 for the first time since 1991, which just so happened to mark the start of one of the greatest bulls ever.

All of a sudden, some of the shrewdest market observers, such as Yale's Robert Shiller, Jeremy Grantham of GMO and Rob Arnott of Research Affiliates - who have all been bearish for years - are starting to sense some opportunities. In fact, Grantham predicts that equity returns over the next seven years will be "much above the average of the last 15 years."

Of course, no one is saying you should bet all your chips on a big rebound. And it could take another six months, or far longer, for the equity market to hit bottom.

But one of the enduring lessons of the past quarter-century is that opportunities to buy stocks at truly cheap prices can be fleeting. That's why some investors are talking about finding disciplined ways to boost their stock exposure modestly to reflect this historical development.

Now, some might call this market timing. But yet another lesson the market has taught us is not to put too much trust in labels (remember the notion of safe, dividend-paying financial stocks?). The idea here isn't to ride market momentum for quick gains. It's to rebalance aggressively back into stocks - while others are fleeing - with the clear understanding that it could take years for this to pay off.

Not all market crashes produce cheap stocks. Think back to the bursting of the technology bubble at the start of this decade. Even though the S&P lost nearly half of its value during that bear, many investors thought equities were still overpriced by the end of the downturn.

Why? A common way to gauge the market is to take current stock prices and divide that by recent earnings to come up with a P/E ratio. Trouble is, in good times, profits can be inflated. And if earnings fall dramatically in bad years, P/Es might temporarily soar. So a more conservative approach, which smooths out anomalies, is to use 10-year average earnings as the E in the P/E (this is a method made famous by Robert Shiller).

Based on this method, the market's P/E ratio fell from nearly 44 in 2000, when the tech bubble peaked, to 22 in 2002, when the bear ended. While that was a steep drop, valuations never came close to touching the historical average of 16.

This time, however, P/E ratios have already pierced that threshold. Today the market's P/E is just 14, down from a peak of nearly 28 in 2007. "This suggests that long-run stock returns from here on will be above average," says Baylor University professor Bill Reichenstein. As the table shows, those who invested when P/Es were 20 or higher saw 10-year annual gains of 1% since 1926. By contrast, investors who bought when P/Es were below 15 - like now - earned more than 10%.

Tom Forester, manager of the Forester Value fund, says that he has been "champing at the bit" to buy cheap stocks. After keeping as much as 20% of his fund's assets in cash a few months ago, the only stock fund manager that made shareholders money last year is now almost fully invested in beaten-down stocks.

1. Rebalance - now

If you're uncomfortable with the notion of changing your long-term strategy, just do what you normally would - rebalance your portfolio back to your original mix. But consider rebalancing now rather than waiting until the end of the year.

If you haven't rebalanced since the crash began in late 2007, you might not realize how your allocation has changed. A 60/40 mix of equities and bonds at the start of 2008 is now only 47% in stocks.

But why rebalance now? Who knows where P/E ratios will be by year's end? "There's a lot of cash on the sidelines, and when people begin to get optimistic, there will be a lot of people trying to fit through a very small door," says David Antonelli, a money manager with MFS Investment Management.

2. Go one step further

With valuations this low, risk-tolerant investors with years to make up for potential losses should also think about boosting their equity stakes slightly. Financial planner Ronald Rog says investors might consider increasing their normal stock weighting by about five percentage points if they think stocks are undervalued. So if you're normally 60% in equities, bump that up to 65%.

An easy way to do that is to take any cash that you may have kept on the side-lines - and that you won't need for at least five years - and gradually work that into the market. But remember that by doing so, you're taking on added risks. This is not the time to be diving into the riskiest end of the equity pool by, say, loading up on shaky financial stocks. Instead, simply rebalance into the diversified mix of stocks you previously settled on.

Now, you might be tempted to be even more aggressive - for instance, by boosting your stock allocation by more than 10 percentage points. But if this market has taught us anything, it's that there are no certainties in investing. So you don't want to risk more money than you can truly afford to lose.