Montreal, Canada

Is there a margin of safety buying common stocks when fundamentals like price-to-book, dividend yield and price-to-earnings are trading at the low end of their historical range? Or, is the individual investor better off chasing momentum and cutting loose when an index breaks its short or long-term moving averages?

In my experience, buying at a low price is the safest and most profitable strategy for the long-term investor.

One of the best empirical studies on buying stocks when they're historically undervalued is David Dreman's Contrarian Investment Strategies: The Next Generation (Simon & Schuster). Dreman, a veteran money-manager, has written several updates on this winning formula. His book covers a host of contrarian investment strategies that has proven to outpace the S&P 500 Index over short and long-term investment periods. I highly recommend this book for value investors.

One of the most widely followed investment indicators is a matrix called the price-to-earnings ratio, or P/E.

The P/E can be calculated by dividing the price of a stock or an index by its per share earnings. More often than not it's a bad idea to buy stocks trading at lofty P/Es; this discipline is further rewarded when combined with a low price-to-book value ratio and above-average paid dividends. Conversely, it's usually a bad idea to buy equities when all of these important ratios are trading at expensive levels.

The S&P 500 Index currently trades at 22 times trailing earnings. That's not cheap. Historically, the U.S. broader market has averaged about 16 times P/E multiple. Every time valuations peaked it did so when the P/E was trading above 20; the only exception is 1936 when the S&P 500 traded at 19 times earnings and continued to surge until the market crashed again starting in 1937.

In 1929, the S&P 500 Index fetched a dizzy 28 times earnings. Twelve months later an investor would have lost more than 80% of his money in stocks. By 1932, however, that multiple compressed to just 8 times earnings and preceded one of the greatest stock market bottoms in history as the market hit a low in the summer of 1932 and then went on to skyrocket more than 350% until prices peaked in 1937.

Again, in 1965, the broader market peaked at a lofty 23 times earnings. By late 1966 a severe bear market smashed stocks and marked one of the worst periods to start a stock portfolio. From 1966 until 1981 stocks posted a loss when adjusted for inflation. They didn't bottom until 1981.

Conversely, the P/E ratio on the S&P 500 Index hit a low of 7 times earnings in 1982, which marked the trough of the 1966 to 1981 bear market and the beginning of the greatest bull market for stocks since the 1950s.

By 2000, the S&P 500 Index, loaded with technology stocks at more than 22% of the benchmark, peaked at 42 times earnings. Consequently, stocks have posted a cumulative loss over the last ten years marking their worst decade of performance since the 1890s. Indeed, the 2000s were even worse than the 1930s.

Though not an exact science and certainly not a reliable market-timing indicator, the P/E ratio is nevertheless a useful valuation tool for contemplating whether investors should buy or sell stocks. More often than not, history has shown us that buying low and selling high usually proves to be a winning long-term strategy.

Right now, investors should be under-weighted stocks as the S&P 500 Index sells at 22 times historical earnings. Historically, this is not the time to own a big position in pricey stocks.

Have a good weekend. See you on Monday.