Roger Conrad, in a leading expert on utility stocks; the editor of Conrad's Utility Forecaster is al...
Stocks Cheap? Overpriced? It Depends
04/21/2011 8:00 am EST
The market seems reasonably priced by most measures, except the one many are citing, writes John Reese of the Validea Hot List .
The issue of value is one that's gotten quite a bit of attention lately, particularly when it comes to the broader market's overall valuation.
As an asset class, are stocks cheap, or are they pricey? That's the question on many investors' minds, and, depending on whom you ask, you'll get some wildly divergent opinions.
Those on the "pricey" side of the debate include top value strategist Jeremy Grantham and Yale economist and noted bubble-spotter Robert Shiller. In January, with the S&P 500 trading fairly close to its current level, Grantham said that the index was about 40% overvalued.
While I don't believe Grantham has divulged the exact details of his fair-market calculation, one valuation metric he relies heavily on, according to a 2010 article in Advisor Perspectives, is one that has been popularized by Shiller (though it was actually pioneered by the late, great value investor Benjamin Graham, one of the gurus upon whom I base my models).
The variable goes by a number of different names—the Shiller P/E, the ten-year P/E, the CAPE (Cyclically Adjusted P/E)—but essentially it compares the S&P's price with its average earnings over the past ten years, with some adjustments for inflation.
The theory: Comparing price to earnings for the past ten years smoothes out anomalous earnings results that pop up in any given year. Shiller's latest calculations (which are available on his Yale web page) show that, as of the beginning of April, the ten-year P/E for the S&P was 23.47—some 45% or so above the long-term average of 16.
Others point to different numbers that paint a strikingly different picture. Wharton professor and author Jeremy Siegel, for example, said not long ago that stocks were still historically cheap. Based on 2011 earnings projections, he said, the S&P 500 was trading about 13% below where it would be with a modest 15 P/E multiple, according to Reuters.
What's more, Siegel said that one must take interest rates into account when determining the market's value. During lower-interest-rate periods (when stocks have less competition from fixed-income assets), investors are willing to pay more for stocks.
He said that historically, if you exclude periods in which rates were above 8%, the average P/E for stocks is 19. That would mean the market was about 43% below average valuation.
Siegel and others say that, while looking at one year of earnings can be misleading, looking at ten years' worth of earnings can also be misleading.
In a recent Wall Street Journal article that looked at the Shiller P/E, Siegel said that keeping earnings from the financial crisis—a "once-in-a-75-year event"—in the assessment of the market's ten-year P/E "doesn't seem to be realistic."
So, two of the market's top minds offer staggeringly different views—stocks are either 45% overvalued, or 43% undervalued—and we're only talking about earnings-related valuation metrics. There are other metrics, like the price/sales and price/book ratios, that can provide other takes on the market's valuation.
Right now, according to Morningstar, the S&P 500's components are trading for 1.3 times sales on average, for example, which isn’t bad at all. That's actually below the 1.5 upper limit my James O'Shaughnessy-based model uses when examining individual stocks, and in the "good value" range my Kenneth Fisher-based model uses.
NEXT: Mind the PEG|pagebreak|
Mind the PEG
The S&P also appears reasonably valued if you use a metric that famous investor Peter Lynch used to analyze individual stocks: the P/E/Growth ratio (PEG), which divides the price/earnings ratio by the earnings growth rate.
Using 2010 earnings, the S&P is currently trading for 15.7 times operating earnings, and 17 times as-reported earnings. Based on an average of the three-, four- and five-year earnings-per-share growth rates, the index's earnings grew at a 22% pace.
For both operating and as-reported earnings, those figures make for a PEG below 1, which would be considered attractive by my Lynch-based model.
If we use the S&P 500's projected 2011 earnings, the PEGs are also attractive. Using Standard & Poor's operating earnings projection of $96.99 for 2011, we get a PEG of 0.86; using S&P's as-reported earnings projection of $97.26, we get a PEG of 0.53.
Of course, you could look at S&P earnings or sales from a variety of other periods to determine a PEG or a price/sales ratio—three-year average earnings or sales, five-year average earnings or sales, etc. And, often, you'll find divergent stories of what the market's valuation is.
To me, the bottom line is this: When it comes to analyzing the stock market's valuation, there's no one metric that you should always rely on, and no silver bullet that will tell you just how cheap or expensive stocks are.
Expensive Works Sometimes
Oh, one more thing, just to further muddy the waters: Just because the broader market appears expensive doesn't mean it won't rise.
For example, back in the early 1990s, the ten-year P/E climbed above 16 (its current historical average) just four months into a bull market that ended up lasting nearly a full decade.
When it crossed that level, the S&P was priced around 372; if you'd sold out of stocks then, and waited to buy back in until the next time the ten-year P/E was below 16, you'd have had to wait until November 2008, when the index was at about 883.
That's an annualized gain of about 5% per year that you'd have missed out on by shunning stocks (and certainly more than that if you'd picked good stocks)—not great, but hardly the disastrous returns you might expect for a period when stocks were usually trading for between 20 and 45 times trailing ten-year earnings.
Overall, I think the various valuation measures show that the market remains at least reasonably valued. But more importantly, there are numerous bargains in individual stocks out there.
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