So What? Heres the point!

It doesn't matter if value-priced stocks are more or less risky than growth stocks if youre only buying 5, 10, or 20 stocks. Your risk hinges on only three issues: 1. Overall market risk 2. Industry risk 3. Risks specific to your stocks Well examine overall market and industry risks, then move on to evaluate the risks specific to individual stocks. Market Risk Even if youre a great stock picker, its tough making money holding stocks in a bear, or downtrending, market. On the other hand, you can make lots of mistakes and still rake in profits in strong markets. Thats where the market expression: Dont mistake a bull market for brains, came from. Consequently, overall market risk is an important factor in the risk equation. Of course, predicting future stock market direction requires knowing which way interest rates, inflation, and a host of additional economic factors are heading. Economists spend their careers trying to discover the answers to these questions, usually without much success. Instead of pondering these unanswerable questions, well gauge market risk by looking at two easily determined factors: is the market currently undervalued or overvalued and is the market currently moving up, or moving down?

Market Valuation
Several studies show a relationship between market risk and the difference between the markets valuation and prevailing interest rates. Its an inverse relationship, meaning low prevailing interest rates support higher market valuations. The S&P 500 Index is usually used as a proxy for the entire market, and most experts express the markets valuation in terms of the S&P 500s price to earnings (P/E) ratio. This P/E ratio is simply the market-weighted average P/E of the stocks making up the index. Market-weighted means the bigger the firm in terms of marketcapitalization, the more weight given to its P/E in the calculation.
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One way to determine where we are in terms of valuation is to invert the markets P/E to get earnings yield. For instance, the yield is 5 percent if the P/E is 20 (1/20 = 0.05 or 5%). Then compare the market yield to prevailing interest rates, typically the three-month U.S. Treasury bill rate. Usually the market yield is higher than the T-bill rate. Whats important is the spread (difference) between the two rates. The market is considered high risk when the spread is low or negative.

Table 2-1 compares market yields, the three-month T-bill rate, and the spread between the two, as of December 31, going back to 1984. The table also shows the following years S&P 500 index returns. For example, Table 2-1 shows that as of December 1994, the market yield was 1.0 percent higher than the T-bill rate, and the S&P 500 moved up 34 percent in the next 12 months. As the case with most market indicators, comparing the market earnings yield to the T-bill rates doesnt always work, but its clear that negative spreads signal higher risk than positive spreads. That makes sense since negative spreads result from low market yields, which correspond to high market valuations (high P/Es).
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TABLE 2-1 Market yields, T-bill interest rates, the spread between the two, and the following years S&P 500 index return. Date Market Yield (E/P) 3-Month T-Bill Spread Following Years S & P Return

12/00 4.2% 6.3% -2.1% -13% 12/99 3.1% 5.3% -2.2% -10% 12/98 3.6% 4.5% -1.4% 20% 12/97 4.5% 5.4% -0.9% 27% 12/96 5.3% 5.1% 0.2% 31% 12/95 5.9% 5.2% 0.7% 20% 12/94 6.7% 5.7% 1.0% 34% 12/93 5.6% 3.1% 2.5% -2% 12/92 5.3% 3.3% 2.0% 7% 12/91 5.6% 3.9% 1.7% 5% 12/90 7.1% 6.7% 0.4% 26% 12/89 7.7% 7.9% -0.2% -7% 12/88 9.1% 8.5% 0.6% 27% 12/87 7.7% 6.0% 1.7% 13% 12/86 7.7% 5.7% 2.0% 2% 12/85 8.3% 7.3% 1.0% 15% 12/84 11.1% 7.9% 3.2% 26%
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Market Direction
Sizing up the current market direction gives you a heads-up as to whether it makes sense to invest new money or stay on the sidelines. A strong uptrend gives you a green light to add to positions, while a strong downtrend advises caution. Since many investors rely on the S&P 500 to represent the market, the easiest way to gauge market direction is to compare the index to its 200-day moving average (MA) (see Figure 2-1). If the S&P is above

its 200-day MA, its probably in an uptrend, and vice versa. The distance between the index and its moving average reflects the trend strength. The trend is strong if the index is far above or below its moving average. It indicates a trendless or consolidating market if the index is hovering near, or crisscrossing, its moving average. The S&P 500 Index reflects the action of large-cap stocks in a wide variety of industries. Other indexes may provide better indications depending on the particular market sector that youre considering. For
FIGURE 2-1 Use MSN Money to display a chart of the S&P 500 Index and its 200-day moving average. Consider the market in an uptrend when the index is above its moving average.
S & P 500 Index 200-day MA

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instance, the Nasdaq reflects the action of tech stocks, and the Russell 2000 index better shows how small-caps are faring. There are a variety of other indexes available to show the action of mid-caps, value or growth stocks, or of individual industries. SectorUpdates. com (www.sectorupdates.com) is a good place to find these indexes. Click on Sector Charts to see the complete list. Its best to avoid buying stocks in a downtrending market unless it belongs to an industry sector showing strength despite the weak overall market.