After eight consecutive days of losses for stocks, mostly thanks to the debt-ceiling crisis, many stock analysts are saying that stocks are oversold. What does that mean and how might that provide clues about the future direction for stocks and mutual funds?
Time Will Tell Who is "Right:" Buyer or Seller
It's important to be periodically reminded that, for each seller of stocks, there is a buyer and that stock prices are influenced by supply and demand. If large numbers of investors want to sell shares of their stocks, prices will have to fall for buyers to purchase those shares. The opposite is also true: if there is an increasing demand to buy stocks, the prices will go higher to entice enough sellers to sell their shares.
Now back to stocks being currently described as "oversold:" Stock analysts value stocks in many ways but the general barometer for stock pricing is the Price/Earnings ratio or P/E, which is means of finding the relative value of a company by dividing a company's stock price (P) by its earnings (E). Looking at the stock market as a whole, stock analysts and investors consider the average P/E of a large number of companies, such as those in an index like the S&P 500. Therefore the S&P 500's P/E ratio can give an investor an overall idea of the markets value
Low Prices Don't Always Mean Good Value
According to Crossing Wall Street, the S&P 500's P/E has dropped to a 21-year low. This indicates that the recent selling of stocks has resulted in lower prices and thus lower P/E ratios. Therefore, this historic low for the S&P 500's P/E ratio could be signalling that the heavy selling (over-selling) of stocks may soon transition into buying by investors looking to snatch up some bargains.
Does this mean that you start buying more shares of stocks and stock mutual funds? Not necessarily. Stock prices are a reflection of what investors believe economic conditions will look like in the near future (3 to 6 months from now). If economic conditions appear as if they will continue to decline, investors will "price in" this anticipation and stock prices can continue to fall. This is where the P/E ratio can be misleading.
Just because stock prices are low does not mean that they are a bargain because the prices can continue to fall further. As I say repeatedly here, long-term investors need not worry themselves with short-term conditions, which is what all media attention centers upon. Your best investment move is to continue to dollar-cost averaging, keep a balanced asset allocation and go on focusing on higher priorities in your life.