Your investing education really begins after you start to recognize just how much you don’t know. When you reach that point, you’ll start to look at a much wider range of data and stock market indicators.

Your investing education really begins after you start to recognize just how much you don’t know. When you reach that point, you’ll start to look at a much wider range of data and indicators.

Stock market indicators that tell a negative story all have the same basic structure. They take some measure of market strength, or value, and compare it to the historical averages. They all touch on at least one of these three factors: how long the market has been rising; how far it has gone up during that rise; or the P/E ratio—the ratio of a stock’s price to per-share earnings. These three types of indicators all measure the same thing, and that’s why they tell the same story.

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Stock market indicators: Don’t rely on them alone

Stock market indicators aim to let you narrow down the range of information that you use to make an investment decision. When you come right down to it, you have two ways to try to profit from stock market indicators. The most common, and the favourite of many investors who are just starting out, is what you might call “the crystal-ball approach.” That’s when you look around for a simple-to-understand, fits-on-a-T-shirt indicator that provides a clear buy-or-sell signal.

The crystal-ball approach will give you random results—a series of wins and losses. In the long run, however, a random approach to investments is more likely to hurt than to help you, just as in any other area of life.

Instead, our Successful Investor approach to indicators is to use them as specialized tools, rather than decision-making devices. Before you rely on a market indicator, you need to consider the information it employs and decide if that slice-of-all-available-info is important enough to provide a clue to the outlook for the market or individual stocks.

Stock market indicators: Shiller P/E Ratio 

Sometimes, indicators rely on a slice of info that sounds scientific, but is of little real use. The best example we’ve ever come across is the Shiller P/E Ratio, also known as the Cyclically Adjusted PE Ratio (CAPE Ratio), created by Dr. Robert Shiller, economics professor at Yale University.

As you know, the P/E ratio is a widely used guide to value in the stock market. It is the ratio between the per-share “P,” or price of a stock, and its per-share “E,” or earnings. Decades ago, before computers and the web, a common rule of thumb was that a P/E below 10.0 was a sign of good value, while a P/E over 20.0 exposed you to above-average risk.

The P/E comes in a number of variations, depending on what “E” you use. Some P/Es are based on the latest 12-months of reported earnings. Others are based on the earnings of the most recent fiscal year, or on estimates of earnings for the current year, or even future years.

Professor Shiller tried to improve on the basic P/E by adjusting the earnings of each of the previous 10 years for inflation, based on yearly changes in the consumer price index. He then averaged those 10 inflation-adjusted years’ earnings. After that he used those figures to compute a long-term history of changes in this “Shiller P/E” for the U.S. S&P 500 stock market index.

The Shiller P/E strikes us as an interesting line of statistical research. But if you look to it for ideas to improve your investment results, it puts you on to the wrong track.

When you consider buying a stock, it’s always a good idea to look at its operating history. For instance, look at yearly figures and trends in its sales, earnings and dividends. You’d want to question why variations occurred. Instead, the Shiller looks at three volatile figures: the stock price, the yearly earnings per share, and yearly inflation figures. In any given year, each of these figures could go up, down or sideways. So, you can get the same Shiller P/E number under 27 different sets of conditions (3 x 3 x 3 = 27), without making any fine distinctions in the factors—just up, down or sideways.

It’s even more misleading to use the Shiller P/E as a guide to the market’s future. That’s what fans of the ratio do when they use it to decide if market risk is high (a bad time to buy) or low (a good time to buy).

Bonus tip: Characteristics of Successful Investor blue chip stocks to add to your portfolio

Blue chip companies can give investors an additional measure of safety in volatile markets. And the best ones offer an attractive combination of moderate P/Es, steady or rising dividend yields (annual dividend divided by the share price) and promising growth prospects.

We feel most investors should hold the bulk of their investment portfolios in blue chip investments that follow our Successful Investor philosophy. All of these stocks should offer good “value”—that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above average-growth prospects, compared to alternative investments.

What stock market indicators have you found to be the best for picking blue chip stocks?

Do you find stock market indicators helpful or do they seem more like a distraction?