After a spooky October, the FTSE 350 is back on the rise. Cheap shares are starting to recover from last year’s correction.
This might just be a temporary boost as we approach the holidays. After all, the short-term performance of the stock market is incredibly difficult to predict. But looking at the Fear & Greed Index, it’s more than doubled over the same period, boosting the rating from extreme fear to neutral.
The upward momentum in investor sentiment may be an early indicator that the long-awaited rally is coming. Maybe it’s already here. As such, snapping up bargains today could be a very lucrative move in the long run.
Separating bargains from bad deals
One of the quickest tools in a value investor’s arsenal is the price-to-earnings (P/E) ratio. It’s a simple and quick metric to calculate. And compared to an industry average, it can uncover whether a stock is trading at a discount relative to its peers.
Right now, there’s an abundance of firms trading at valuations that are massively discounted compared to a few years ago. But it’s critical to remember that a low P/E ratio doesn’t guarantee a bargain. In fact, it might be an indicator to stay away.
Panic-selling investors often make dumb decisions to try and minimise losses. Loss aversion is a powerful emotional response. And it’s not easy to overcome, and failing to do so is why so many investors make costly mistakes. At least, that’s what I think.
However, when a stock gets sold off, there’s almost always a catalyst that starts triggering this downward momentum. And in some instances, a mass exit of shareholders may be justified. For example, a firm whose products have just become obsolete due to a competitor is likely to be a terrible investment, even if the P/E ratio looks absurdly cheap.
On the other hand, a temporary hiccup in operations that leads to a missed quarterly earnings target may be a more promising long-term buying opportunity.
When will the rally start?
History has shown countless times that snapping up cheap shares just before a stock market rally can generate enormous wealth in the long run. And in retrospect, it’s easy to say, “I should have invested here”.
But at the moment, it’s impossible to know whether now is the right time to buy. Even today, with market indicators suggesting that the worst is over, there may be another dip just over the horizon. Sadly, there’s no way of knowing for sure until after it happens. And by then, it’s usually too late to capitalise on mass-discounted valuations.
That’s why using a pound-cost averaging strategy is my preferred tactic during these types of market conditions. By drip-feeding capital into top-notch stocks each month, an investor can capitalise on the bargains today and still have money in the near term to buy more shares at even better prices should conditions suddenly worsen.
Even if a portfolio only matches the FTSE 350’s average 9% return, drip feeding £350 each month can build a portfolio worth £392,400 in 25 years. Future crashes and corrections may extend this timeline, but a prudent investing strategy can still help significantly improve an investor’s financial position.