We often hear investors talk about buying undervalued stocks, but what does that mean and are we in a situation today where we can take advantage of low prices?

The typical definition of an undervalued stock is one that is trading at a historically low price to earnings multiple. A company that earns $1 a share and trades at 10 times earnings will trade at $10 a share. If that company tends to trade around 10 times earnings over a five year period but is currently trading at 8 times earnings, the value investor will say that it is undervalued. The expectation is that its price will eventually rise back up to its historical average.

The problem with this approach is that it opposes the idea that the stock market is efficient. What if the company’s products are not selling as well as they have over the past five years or what if the company’s rate of growth has slowed because of a weak economy? There may be very good fundamental justification for the lower price to earnings multiple.

Therefore, if investors are going to seek out stocks that are “cheap” we need to make sure that the market has made some sort of mistake in valuing them. We need to exploit breakdowns in market efficiency.

There are two primary assumptions of market efficiency that can be the source of a breakdown. First, we assume that investors have access to the same information. Second, we assume that investors act rationally.

What if our example company, trading at 8 times earnings, is a Biotechnology firm and the company discovers an important cure for a pervasive disease? If most investors do not know about this discovery, the stock will continue to trade around its current price. However, for the investor who has this new and not yet public information, the stock is undervalued. Once the market learns about the company’s new drug and its market potential, the stock should rise to price in the expected increase in earnings.

In this case, the stock is only undervalued to the investor who has better information than most investors. For an investor with a great deal of expertise in an industry and a willingness to invest the time and resources necessary to uncovering private information, this strategy for exploiting a break down in market efficiency is a good one. However, for most investors, this approach is not realistic.

This takes us to the second way that market efficiency can break down. Identifying times when the market is not acting rationally because of emotion can lead to market beating returns. Historically, anyone buying a market gripped by fear or selling a market in the clutches of greed has led to extraordinary profits. In the last three years, we have seen a lot of substantial price moves that have come out of the emotion of the market.

Since the end of April, we have had a market trading with a good deal of fear and uncertainty. Investors are unsure about the state of the global economy and have an even greater degree of uncertainty about debt issues in Europe, primarily in Greece, Portugal, Italy, Ireland and Spain. The fear is that bankruptcy by any of these countries could lead to a meltdown of the global financial system. That fear and uncertainty is why the market has been a yo-yo of price volatility.

Fear causes a market to trade for less than it is worth so we can say that this market, in general, is undervalued. The data supports this as company earnings have been improving over the past three years but prices have failed to rally. The average earnings multiple for stocks is lower than average.

The question we must answer is whether stocks are trading at lower earnings multiple because of an expectation that future earnings will be less or because investors are scared and uncertain about the future causing them to want to pay less for stocks.

There is evidence that fear is widespread in the stock market right now. The VIX index, a measure of implied option volatility and often referred to as the fear index, has been trending higher since early August. You can see a chart for this by looking at the VIX ETF, VXX.

The market for US Treasury Bonds recently hit new highs and has been trending upward since early August. You can see a chart for this by looking at the ETF, TLT.

Finally, despite the US Federal Reserve’s effort to devalue the US Dollar by printing more of them, the US Dollar has been very strong relative to other currencies over the late summer. Money has been seeking safety in the US Dollar.

Unless you believe in a financial apocalypse, these trends in the VIX, Treasury Bonds and the US Dollar are irrational and are instead motivated by fear. That means there is an opportunity to buy stocks that are undervalued.

Therefore, we should be looking to buy stocks that have suffered significant sell offs because of fear. However, trying to catch a falling knife is a dangerous game, so it is important that we time it right.

There are signs that the market is beginning to come out of its fear induced fog. The VIX has retraced significantly over the past two weeks as has the US Dollar and US Treasuries. Meanwhile, money has started to come back to stocks; the US stock market has made some very good gains over the same time period.

The Canadian market has lagged the US recovery but has risen enough to now threaten its long term downward trend line. A break of this line of emotional resistance would be a good sign that we have made bottom and are starting a period of price recovery. The chart of the TSX 60 ETF, T.XIU is an important one to consider if you are looking to come back to Canadian stocks, watch for a break of its downward trend line.

If you consider the seasonal tendencies of the market, now is the time to start buying stocks. The market tends to do be strong from October until the end of April and weak from May until the end of September.

The problem for most investors is that they feel the fear that pervades the market and find it emotionally difficult to buy stocks. If you are like most normal people, you will shun stocks at times like this and only return after they have gone up enough to feel a renewed sense of confidence. Unfortunately, the opportunity for market beating profits will have passed by the time investors are feeling confident again. The time to make the trade is when it feels difficult to do so.

Trying to pick a bottom in the market is a difficult thing to do. We have to expect that we may time it wrong and we have to be willing to take a loss if we come in too early. It is important to move in to the market slowly and build positions as the market confirms the bottom.

There are a lot of signs that the market has bottomed, making this a good time to start buying stocks again. While I think the market will be higher in the months ahead, I am not certain that prices won’t be lower than where they are right now. As long as the market does not move to new lows, I think it is a good time to buy pull backs as the market works on its recovery.