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2011 was a year in which the market moved about three miles yet only traveled about an inch or two forward when all was said and done. Fears of economic weakness both at home and overseas kept many investors on the sidelines.
According to Forbes, in the first 11 months of 2011, investors stuffed $889 billion into low-yielding checking and savings accounts, more than eight times as much as the $109 billion that flowed into stocks and bond funds. But while Main Street investors remain reluctant to embrace equities, some big-name professionals are finding a lot to like in today's volatile stock market.
Back in the saddle
Hedge fund manager David Einhorn, a well-known short-seller, is singing a more upbeat tune on U.S. stocks. Einhorn, who famously shorted Lehman Brothers before its collapse in the fall of 2008, believes many stocks are undervalued enough that they are still attractive, even if the economy encounters more difficulties down the road. His hedge fund, Greenlight Capital, is more net long in stocks than it has been in quite some time. As part of his bet on undervalued stocks with strong business fundamentals, Einhorn purchased Dell (Nasdaq: DELL ) and Xerox (NYSE: XRX ) in the last quarter of the year.
So are stocks really as undervalued as Einhorn and some others believe them to be? Well, it depends on what valuation measures you're looking at. According to data from Birinyi Associates, the current trailing-12-month price-to-earnings ratio based on "as-reported" earnings for the S&P 500 through last week was 15.1, just under the long-term average of 15.5, as calculated by finance guru Robert Shiller. Furthermore, the estimated 12-month forward P/E for the index is an attractive 12.5.
However, by other measures, the market is not such a bargain. Again turning to Robert Shiller's data, the cyclically adjusted price-to-earnings ratio, or CAPE, is a modified P/E measure that includes a denominator that is average inflation-adjusted earnings over the trailing 10 years. The latest data for January 2012 indicate that this measure for the S&P 500 is 21.1, quite a bit more than the long-term average of 16.4, going back to 1881. So declaring the market to be undervalued or overvalued depends greatly on which valuation measure you decide to use.
But regardless of whether you think stocks are undervalued, fairly valued, or even a bit richly valued, there's one thing investors can count on in the coming years -- even if stock returns aren't stellar, they will still beat bonds. Bonds have had a tremendous multidecade run, with historically low interest rates helping to inflate prices.
But the economic factors behind bonds' incredible recent stretch of performance just aren't repeatable to any large degree looking ahead. While rates will likely remain low for some time into the immediate future, the only place rates have to go is up, which means the only direction bond prices have to go is down. I don't think we'll see a hard collapse of prices, but rather a slow deflation over time. That means it won't take much for stocks to outperform bonds in the coming years.
So if you're one of the millions of investors who have been enriching their low-yield checking or savings accounts out of fear, take a cue from manager David Einhorn and pick up some undervalued names with the financial strength to weather any economic fallout that may be coming our way in 2012. Given where we are in the current market cycle, that means fishing in large-cap waters and looking for financially stable industry leaders.
To home in on undervalued names, pick up a well-diversified mutual fund or exchange-traded fund that focuses on low-P/E names. The iShares S&P 500 Value Index ETF (NYSE: IVE ) will only set you back 0.18% while giving you access to more than 300 low-priced companies. If you really want to bump up the growth potential in your portfolio, think about adding a fund that leans into that corner of the market. For just 0.12%, the Vanguard Growth ETF (NYSE: VUG ) invests in some of the fastest-growing names in the large-cap market. Another way to identify potential winners is to look for companies with healthy and growing dividends. In that case, a low-cost fund like Vanguard Dividend Appreciation (NYSE: VIG ) is a sure thing -- for a low 0.12% price of admission, you'll get a hefty helping of stocks with a history of increasing dividends over time.
Stocks may not be easy to hold in the coming years, but they still look to provide some of the greatest long-term returns. So make sure you're ready for the next phase of the stock market's rise.
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