It’s the start of a new financial year and I’m figuring out what to do with my annual ISA allowance. Should I keep it in cash, or invest it in the stock market?
High inflation and rising interest rates are a reason for thinking share prices might be on their way down. But I see now as a good time to be investing in stocks.
What’s next for the stock market?
Since the start of the year, the FTSE 100 is up 1.5% and the FTSE 250 is down 2%. But there are reasons for thinking prices will come under increasing pressure this year.
In the UK, interest rates have been rising steadily, creating a headwind for share prices. And I can understand why many think this is likely to continue this year.
Interest rates have been going up as the Bank of England attempts to bring inflation back down to (somewhere near) 2%. Unfortunately, there are a couple of problems here.
The first is that it doesn’t seem to be working. The most recent reading recorded inflation moving higher, from 10.1% to 10.4%.
Second, the area where prices seem to be persistently high is food. Higher interest rates don’t really have much impact here – people don’t stop eating because returns on cash are higher.
So I think interest rates could have further to rise and this might be an issue for share prices. Despite this, I also believe now is a good time to invest in the stock market.
What matters when buying shares
When I look at how the best investors approach the stock market, they don’t base their decisions on interest rate forecasts. Also, they don’t make predictions about what share prices will do in the next few months.
For the best investors – like Warren Buffett and Howard Marks – these aren’t the things that matter. What’s important is buying shares in companies at prices where the future returns look good.
Whether or not a stock is trading at an attractive price comes down to how much money the company is going to make. Any company can be a bad investment if its price is too high for its future earnings.
So the question for investors like me to consider is whether the stock market is allowing opportunities to buy shares in businesses that are low compared to the cash they produce. And I think it is.
The FTSE 100 currently trades at a price-to-earnings (P/E) ratio of 11, which implies an earnings yield of 9%. And the P/E ratio of the FTSE 250 at the moment is 10.5, meaning a 9.5% earnings yield.
Neither of these look particularly expensive to me. As a result, I think it’s likely there are good opportunities right now for investors.
Finding stocks to buy
I’m not saying that share prices won’t go down for the rest of the year. I don’t think it’s possible to know what share prices will do, so I can’t rule this out.
The FTSE 100 and the FTSE 250 trading at low P/E ratios doesn’t tell me which stocks to buy. It tells me there are probably good investments to be made. But my job as an investor is to figure out what they are.
This post was originally published on Motley Fool
