Expert Summit: Are Stocks Still Undervalued?

The market has run a hefty 51% since its bottom on March 9. Stocks like Diamond Offshore (NYSE: DO  ) and EMC (NYSE: EMC  ) have even outpaced the benchmark, running up more than 60%.

However, according to Thomson Reuters, while 73% of the S&P 500 companies beat second-quarter earnings expectations, 52% of those same companies posted worse-than-forecast revenue growth. The earnings beats from companies like Caterpillar (NYSE: CAT  ) and IBM (NYSE: IBM  ) were largely due to cost-cutting measures.

A run-up in prices and a mixed growth picture prompt the question: Are stocks still undervalued at current price levels? You can purchase the best companies in the world, but if you buy them when they're overvalued (or even at fair value), you're hurting your odds of making money in the market.

To gain insight into where valuations stand right now, I spoke to a panel of experts:

  • Bob Doll, vice chairman and global chief investment officer of equities at BlackRock
  • David Kelly, chief market strategist at JPMorgan Funds
  • Uri Landesman, head of global growth at ING Investment Management
  • John Linehan, co-director of T. Rowe Price's U.S. equity division and portfolio manager of the T. Rowe Price Value Fund

What follows is an edited version of what our experts had to say:

How are valuations on stocks now across the board?

David Kelly: They're expensive if you look at the last year of earnings. Over the last 20 years, the P/E ratio of the S&P 500, looking at operating earnings, has been 19.6 times the last year of operating earnings. Right now we're running at about probably 25 times the last year of operating earnings. The last year we did $40, all told, on S&P 500 operating earnings with the S&P just over 1,000. So at 25 times earnings that is above normal.

But I think it's important to be a little forward looking here. That $40 in operating earnings over the last year is extraordinary. It won't be repeated I hope. We're already at a run rate on operating earnings of about $60.

By 2011, I think we'll probably be back to where we were in 2007. So if you get earnings back up to $80, say in the next two years, and the S&P 500 didn't go up from here then you're talking about a P/E ratio of 12.5 times as opposed to 25 times.

I think if you assume there will be a normal recovery of the economy, and therefore a recovery to normal levels on earnings from the incredibly low levels we've seen in the last year, if you look at that, then stocks are still somewhat cheap.

Bob Doll: All together I would say mixed, or generally fairly valued. On the one hand you have stocks pretty cheap relative to inflation and cash -- both of those numbers are not far from zero. [They're] cheap relative to Treasury rates, but not all that cheap relative to spread product, corporate credit, and high yield. Putting it all together, the stock market is pretty fairly valued up from its undervaluation we saw not too long ago.

John Linehan: It depends on what you expect. If you look at this year we're expensive. We're trading just under 20 times consensus S&P earnings for the year. That doesn't seem cheap at all. But if you look at next year we're just under 15 times consensus, so that looks a little more appealing.

Uri Landesman: I think valuations are still pretty reasonable. There are still a lot of companies trading at or near the low end of their historic multiples. So I think there is a decent valuation underpinning here, but that of course assumes that profits are going to recover a little bit.

For more insight from these experts:

Jennifer Schonberger does not own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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