The Market May Be Cheaper Than You Think

How much froth remains in the market? ''I'd say it's still 50 to 60 percent overvalued,'' Mr. Tice said. Based on trailing earnings, he said, the price-to-earnings ratio of the S.& P. 500 is now above 30, and could fall to as low as 10 to 12.

Before freaking out, know that this quote is from a New York Times articled dated September 2002, just as stocks were bottoming. The S&P 500 nearly doubled in the ensuing five years, and investors learned the painful lesson that using trailing P/E ratios coming out of a recession can be the dumbest thing they ever do.

But it never gets old
Most still haven't learned. In a pretty flagrant attempt to terrify readers yesterday, MarketWatch columnist Paul Farrell warned that "economist Gary Shilling said price-to-earnings ratios are at a 'nosebleed 22.5 level.'" This isn't an uncommon view. Watch CNBC for a few minutes and you'll be inundated with bobbleheads saying the market isn't just overvalued, but disturbingly so. Their reason? Look at trailing P/E multiples. That's all the evidence you need to be horrified.

There's reason to worry these days, but I'd beg to differ on this point. If we're going to get wound up about market multiples, it's important not to use numbers that maim reality. Using more practical figures shows the market is far cheaper than many people think.

In this case, we're talking about index earnings on the S&P 500 average. This is simply the sum of what all S&P 500 companies earned in a given period. Over the past five years, here's what you get:

Divide today's S&P level of 1,075 by last year's earnings of $50.97 and you get a P/E ratio of about 21, which scares people silly seeing how the long-term average is closer to 16.

But remember two things:

• Both 2008 and 2009 were absolutely horrendous years, not even slightly indicative of corporate America's real long-term earnings power.
• Markets are forward-looking.

To the first point, 2009's earnings obviously incorporate Q1 2009, which was near the peak of the bank flushout when the financial sector (which makes up 16.26% of the S&P 500) was losing more money than anyone thought imaginable. In Q1 2009, the entire S&P 500 index earned $7.52, or an annualized $30.08, which adjusted for inflation is actually the same amount it earned in 1964. When numbers fall back to the days when computers looked like this, it's not a reflection of true earnings power, or even the bottom end of a cycle. It's a statistical breakdown that shouldn't be taken very seriously.

You can say something similar about the CAPE (Cyclically Adjusted P/E) ratio popularized by Yale economist Robert Shiller, which calculates the 10-year inflation-adjusted earnings average. Although this metric logically makes a lot of sense, its relevancy has been diminished by the financial sector's 2008-2009 meltdown. The problem with using CAPE right now is the assumption that the past two years were part a normal business cycle when in fact they were more of a nuclear firestorm.

These weren't once-in-a-business-cycle losses. These were the kind of losses you might see once or twice in a lifetime. As Wharton professor Jeremy Siegel said of CAPE, "AIG's $80 billion write-off is going to pollute those figures for 10 years." Ditto for most other financials. Freddie Mac, an S&P 500 member until late 2008, made a combined $25 billion from 2000-2007 and then lost $50 billion in 2008. A few spectacular swings like that can distort CAPE as a measure of broad corporate profitability. Some contend that these swings are simply the other side of a profit bubble, but profits made earlier in the decade can be excessively drowned out in CAPE's calculations since financial-sector losses were accentuated by ridiculous leverage.

Eye on the prize
More important, though, is the second point: that markets are forward-looking. S&P has an analyst named Howard Silverblatt whose job is to keep track of current S&P 500 earnings and predict future earnings one year out. His estimates are usually seen as the most reputable because (a) his views aren't swayed by clients' interests, and (b) this is all he does.

Here's what his latest numbers show:

With the S&P at 1,075, $80.92 of earnings in 2011 brings a P/E ratio of about 13, which is plainly cheap. Even if those projections are wildly off and earnings turn out closer to 2010's estimate of $64.81, current market levels bring a P/E ratio of around 16, which is hard to say is expensive by almost any measure. Plus, remember that both short- and long-term interest rates are at historical lows right now, so valuations are actually justified to be above average.

Scanning for individual examples, it can become even more cheery:                      

Source: Capital IQ, a division of Standard & Poor's

Your turn
I'm not overly ecstatic about the market, but that's only because economic ruptures could cause another irrational panic. Arguing that the market is overvalued isn't the slam-dunk case some describe it as. But I know there are legions of you out there who disagree, and I'd love to hear from you. Have at it in the comments section lower on this page.