Are Stocks Cheap? 3 Powerful Indicators, and One Surprise

Last Updated May 14, 2011 11:09 PM EDT

There are few questions that neurotically nag at equity investors as often as this one: Are stocks cheap or expensive? (Of course what we're really asking is: If I buy, will they go up, but that sounds less sophisticated.) Our greedy brain tells us to snap up bargains like a Buffett while our fear brain worries that we're getting fleeced by the next Pets.com.

No doubt valuation is important. Behavioral economists point out that stocks are the one thing customers clamor for only when they're overpriced -- which is why most of the money pours into the market right before the bubble bursts -- and the one thing they won't touch when they're on sale -- which is why bear markets can last a long time.

So, are stocks as an asset class, right now, in this very moment of time, cheap or expensive?

The answer is...Yes.

By short-term price/earnings ratio, stocks look fairly cheap. The trailing P/E on the S&P 500 stands at less than 17, according to data from Thomson Reuters, which is not too out of whack by historical standards.

Looking at the less-reliable forward P/E (which is based on analysts' average guesstimates of future earnings), stocks look like a bargain. The forward P/E on the S&P 500 is below 14, according to Birinyi Associates. Now that's cheap. In bubble times that number gets into the 20s. Of course, stocks can, and have, gotten a lot cheaper.

However, by another respected measure stocks are hardly inexpensive at all. Indeed, they are horribly overpriced if you look at something called cyclically adjusted price-earnings ratios (CAPE). The advantage of this method is that it smooths out the effects on profits from the economic cycle -- and should theoretically revert to the mean over time.

Economist Robert Shiller reckons that the cyclically adjusted P/E stands at nearly 25. If this CAPE thing reverts to the mean, boy, are we in trouble, since the long-term median stands at about 16. (For the record, CAPE hit an all-time high of 44 in December 1999 and an all-time low of 5 in December 1920.)

It's this cyclically adjusted way of measuring stocks that leads some market mavens to conclude equity returns are destined to disappoint for a decade or more. John Hussman, for example, the rightly well-regarded manager of the Hussman Funds, estimates "the S&P 500 is priced to achieve 10-year returns of about 3.43 percent annually."

That would stink.

But maybe our 401(k) futures are not as dire as CAPE would predict. As my colleague Carla Fried wrote recently, there's a credible case that stock returns over the next decade are poised to deliver returns in line with their long-term historical trend.

Now another new study argues that measuring stocks by cyclically adjusted P/Es doesn't really make sense these days, seeing how zany -- how "unsmoothable" -- the last 10 years have been.

True, the market has come very far very fast, spooking plenty of CAPE-watchers, but that doesn't necessarily make cyclically adjusted earnings a good yardstick now, write Richard Kopcke and Zhenya Karamcheva of the Center for Retirement Research at Boston College, in a new research paper:
Companies' earnings have recovered strongly, too. Consequently, cyclically adjusted earnings will tend to increase at double digit rates this year and next, as its 10-year moving average replaces low earnings from 2001 and 2002 with today's much higher earnings. Accordingly, the currently lofty price-earnings ratio for cyclically-adjusted earnings will likely fall significantly as this measure of earnings grows more rapidly than stock prices during the next two years.
In other words, by the end of next year, P/E's based on annual earnings and cyclically-adjusted earnings are both likely to match their long-term averages much more closely, "thereby offering investors one of their highest earnings yields in two decades," the authors conclude.

Either way, CBS MoneyWatch believes in keeping your eyes on the prize, which means indexing, judiciously rebalancing your portfolio to maintain target asset allocations -- and keeping long horizons. If you have a plan and stick to it, the question of whether stocks are cheap or dear right now shouldn't keep you up at night. But if it does, just think about cyclically adjusted Price/Earnings ratios. If that doesn't put you to sleep, nothing will.

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    Dan Burrows, a veteran of Aol's DailyFinance, SmartMoney and MarketWatch from Dow Jones, covers the markets and economy with an eye toward investing for the long haul.

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