In the first post of this series we looked at when to buy and sell: Buy when fear is rampant and sell when greed reaches all levels of society in the current market.
In the second post of the series we looked at what to buy.
Buffett already tells us to use price fluctuations to our advantage with the following quote:
Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
So, how do we know when is the right time to buy and sell? What do the prices look like?
In general a long up-trend will end after asset prices are above the long-term valuation by a standard deviation or more.
Here are 3 good examples from recent experience:
- The technology-driven Nasdaq stock market peaked in March 2000 with the PE (price to earnings) ratio reaching 264 while the more mature Dow 30 index peaked at 42 when the 100-year average is only 14 to 21. In these cases people were paying a very high price for not very much earnings.
- During the residential real estate bubble which peaked in 2005, home prices in some bubble markets had climbed to twice their traditional price to rent ratio. Essentially prices doubled but rents stayed the same. This is unsustainable in the long term because people would eventually choose to rent when they can save so much money each month.
- During the commercial real estate bubble that peaked in 2007, the cap rates had fallen so low that instead of a traditional 10% cap rate, many markets were priced at a 7% or 8% cap. Some coastal markets were even in the 3-4% cap rate range. This was a time when interest rates were rising even above the cap rate — that implies the buyers were banking on appreciating prices only, not current cash flow.
Here’s an example from personal experience. In 2006 I owned some lower-end mid-tier quality rental units in the Dallas/Fort Worth area of Texas. The tenants earned about $25,000 per year and paid around $600 per month in rent.
In early 2006, one of my tenants mentioned to me that she wanted to start flipping houses! This was a clear sign that the last possible buyers had entered the market and the only place for the real estate market was to go down (which it ultimately did starting in 2006).
In case you are wondering, I already had this property for sale and fortunately it sold in March 2006 before the complete collapse of prices.
The summary of the past three articles in this series is to buy quality assets below their long-term conservative valuation at a time when the masses are selling in fear. A good paraphrase of Warren is Buffett to buy value when others are selling it — in other words, the asset is “on sale”.
You may also find these Motley Fool articles interesting:
CSPAN Interview: Janet Tavakoli on the Financial Crisis
Warren Buffett Says, Stop Coddling the Super Rich!
Mort Zuckerman Discusses the Economic Recovery Roadmap
Sam Zell Speaks at Milken Conference about Commercial Real Estate
Buying Real Estate for Cash Flow: Summary
Invest Like Jesse Livermore, Technical Trend Trader
Invest Like Philip Fisher, Father of Growth Stock Investing
Invest Like William O’Neil, Inventor of CAN SLIM