Bear Rebuttal: The Market Is Pricier Than You Think

I have been warning for months that stocks are, in aggregate, overvalued. Last week, my colleague Morgan Housel took the opposite position, arguing that the market may be cheaper than you think. I've examined Morgan's arguments, and I remain of the belief that stocks are expensive. Here is my rejoinder:

The most reliable earnings multiple out there
One of the central pieces of evidence for stocks' overvaluation is the cyclically adjusted P/E ratio (CAPE). Pioneered by Robert Shiller of Yale, the CAPE is based on a moving average of inflation-adjusted earnings over the previous 10 years. Currently, the CAPE for the S&P 500 is 19.9, which is 21% higher than the long-term historical average of 16.4.

Expect a small positive return
Professor Shiller, who has compiled stock market data going back to 1871, found that when the CAPE hits 20, stocks lost 2% annually, on average, after inflation. Add dividends in, and investors managed to eke out a small positive return.

Trailing P/E multiples are flawed
In his article, Morgan suggested that stock market bears are misguided in looking at P/E multiples based on trailing earnings. Naturally, as we exit a deep recession, trailing earnings are depressed, producing inflated multiples that make the market look artificially expensive. I entirely agree. However, he then tries to extend the argument to the CAPE:

You can say something similar about the CAPE (Cyclically Adjusted P/E) ratio popularized by Yale economist Robert Shiller... 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.

The CAPE: It does what it says on the box
A plausible argument; however, the numbers simply don't support it. Looking at Robert Shiller's data, the 10-year average real earnings figure one uses to calculate the CAPE for the S&P 500 as of May 2010 is $54.86. Now, let's go back a bit to December 2006 -- before the credit crisis began and, thus, before AIG (NYSE: AIG  ) or any of the banks experienced significant mortgage-related losses. What was the equivalent average earnings figure then? $55.21 -- less than 1% higher than the current figure. In other words, these "once or twice in a lifetime" losses have had virtually no impact on the average earnings used to calculate the CAPE.

Meanwhile, trailing-12-month earnings to the fourth quarter 2006 for the S&P 500 earnings were $78.57, over 30% higher than trailing 12 months earnings through the first quarter of this year ($60.93).

It should be clear that average earnings used to derive the CAPE are much more stable than trailing-12-month earnings -- that's the whole point of the CAPE. I agree with Morgan's critique of P/E multiples based on trailing earnings, but the same can't be said of the CAPE, which was conceived in order to avoid this very shortcoming.

Overvalued index, undervalued stocks
So the bad news is that stocks are indeed overvalued in aggregate, but all is not lost for stockpickers. Some individual stocks belonging to outstanding businesses look undervalued -- even on the basis of the CAPE -- as the following table proves:

Company

Cyclically Adjusted P/E Multiple (May 25, 2010)

Consensus Long-Term EPS Growth Rate / Dividend Yield

Phillip Morris International (NYSE: PM  )

12.4

9.8% / 5.2%

Molson Coors (NYSE: TAP  )

12.9

12% / 2.7%

Chevron (NYSE: CVX  )

7.4

14.1% / 3.9%

UnitedHealth Group (NYSE: UNH  )

8.6

12.2% / 0.1%

Raytheon (NYSE: RTN  )

10.0

9.6% / 2.9%

Source: Author's calculations and Capital IQ, a division of Standard & Poor's.

Not that one shouldn't expect these stocks to avoid the downdraft in a market correction. However, owning shares in high-quality businesses that are trading at or below fair value offers investors protection -- unlike owning index funds when the index is overvalued.

Two types of investors, two suggestions
In this context, investors in individual stocks should assure themselves that each of their holdings is no worse than fairly valued. Meanwhile, index investors (through the SPDR S&P 500 ETF (NYSE: SPY  ) , for example) should be underweight U.S. stocks right now -- the time to be significantly overweight a broad index is once it has declined well below fair value, not while that occurrence is merely a tangible threat.

Between high valuations and sluggish growth, investors can expect disappointing returns from U.S. stocks over the next several years. The good news is that there are alternatives for your money. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. UnitedHealth Group is a Motley Fool Inside Value recommendation. UnitedHealth Group is a Motley Fool Stock Advisor pick. Philip Morris International is a Motley Fool Global Gains choice. The Fool owns shares of UnitedHealth Group. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (17) | Recommend This Article (25)

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  • Report this Comment On June 02, 2010, at 12:15 PM, TMFHousel wrote:

    I'm happy to admit: Alex's analysis is pretty convincing, and changed most of my critical views of CAPE. I still hold the theory that if S&P's estimates for 2010-2011 earnings are even somewhat accurate, the market isn't as overvalued as some think.

    Behold the power of debate.

    -Morgan

  • Report this Comment On June 02, 2010, at 1:02 PM, njdo wrote:

    How can Buffett excuse the rating agencies for not predicting the dire straits we're in. Isn't that like missing the elephant sitting in your living room. It sounds like he's completely compromised, just doesn't want to admit the extent of the corruption and double dealing that exists in the market with inside players like Goldman Sachs repeatedly shearing the sheep and laughing all the way to the bank. I'm more of the opinion that this catastrophe is the result of purposeful manipulation, just follow the money trail and the increasing concentration of wealth in the hands of a shrinking group of players. Just like the credit card companies who keep increasing your limits till you overextend yourself and miss a monthly payment, then bang you with high rates.

  • Report this Comment On June 02, 2010, at 2:31 PM, grant224 wrote:

    "Just like the credit card companies who keep increasing your limits till you overextend yourself and miss a monthly payment, then bang you with high rates."

    If the limit of your credit card is indicative of the amount you charge then clearly you are not mature enough to handle a credit card, and you should be "banged" with higher rates. As far as companies targeting and marketing specifically to irresponsible buyers, that is a separate issue, and not one that should cloud general consumer responsibility.

    As far as underpriced stocks go ( which I think is the purpose of this article) Bristol Myers has been looking attractive to me, especially with a potential melanoma treatment in the works. Also Baxter has taken a beating as of late..

    Opinions?

  • Report this Comment On June 02, 2010, at 3:46 PM, ETFsRule wrote:

    There are a lot of problems with CAPE. If you compare today's CAPE value to a historical CAPE value, you are basically making the underlying assumption that earnings should to continue to grow at the same rate that they grew 50 or 100 years ago.

    When you're looking at the market's average earnings over a 10-year period, growth is going to be a big part of the equation. So, to me it just doesn't make sense to compare today's CAPE value to the CAPE from 50 or 100 years ago.

    The best way to come up with a fair value for the market is to look at 2 things:

    1. P/B ratio of the S&P 500. This is by far the best indicator. It's a simple ratio that you can take at any point in time. And it's much less volatile than the PE ratio.

    2. PE ratio. I don't think there is any "right" way to do it, so you need to look at the PE from a lot of different angles. Look at the TTM PE, the projected PE, and the CAPE.

    Some of these PE's might look overvalued, and others may look undervalued: it's a judgement call. So you should look at all 3, mix them around in your brain, and try to balance them all with a little common sense. Personally I think the best PE to use is the projected PE. But really, the P/B ratio is going to be a more reliable indicator than any of them.

  • Report this Comment On June 02, 2010, at 3:59 PM, junaidfarooq wrote:

    Alex, thank you for the article. I see the logic behind using CAPE for mature companies but how do you use CAPE for a company that has been growing its operations - geographically and along product lines - over the decade and has put substantial capital to work long the way. Using CAPE then would systematically overvalue such a company and would imply that the company would shrink in size (and in earnings). Then for a companies in growth phase and which have have a successful track record of creating value for shareholders by superior capital allocation decisions would always be penalized.

    Opinions?

  • Report this Comment On June 02, 2010, at 11:17 PM, TMFAleph1 wrote:

    @ETFsRule,

    Thanks for your comment,

    CAPE is superior to the Price/ Book Value, Trailing P/E and Forward P/E multiples. For a complete discussion of why this is the case, let me refer you to Andrew Smithers' and Stephen Wright's outstanding 'Valuing Wall Street', http://www.valuingwallstreet.com/.

    Alex D

  • Report this Comment On June 02, 2010, at 11:26 PM, TMFAleph1 wrote:

    @junaidfarooq,

    Honestly, no single metric is perfectly suited to valuing individual companies. The CAPE is excellent for valuing the overall market, because the characteristics of the index are much more stable than that for nearly any individual stock (you are correct that, among individual stocks, the CAPE works best for stable, mature companies).

    As far as individual stocks go, I would recommend looking at a number of market multiples, along with private market values (i.e. M&A multiples) and a discounted cash flow valuation.

    Best,

    Alex D

  • Report this Comment On June 03, 2010, at 12:03 AM, goalie37 wrote:

    Good article, but I would be very hesitant to put an "Overpriced" or "Underpriced" label based on one equation. CAPE deserves its place along with P/E, dividend yield, free cash flow yield, and the myriad of other equations used in our research.

  • Report this Comment On June 03, 2010, at 12:13 AM, goalie37 wrote:

    I have a question regarding CAPE, and please forgive my ignorance. Wouldn't using 10 years earnings make companies with good growth look worse than companies with slower growth?

  • Report this Comment On June 03, 2010, at 12:26 AM, TMFAleph1 wrote:

    "Good article, but I would be very hesitant to put an "Overpriced" or "Underpriced" label based on one equation."

    goalie37, your point here is well taken.

    On a slightly different note: In each of the last two secular bear markets, the CAPE has been in single digits during multiple periods, each of which lasted for months. Since the current secular bear market began in 2000, there has not been one day with a single-digit CAPE!

    Best,

    Alex D

  • Report this Comment On June 03, 2010, at 12:36 AM, TMFAleph1 wrote:

    "I have a question regarding CAPE, and please forgive my ignorance. Wouldn't using 10 years earnings make companies with good growth look worse than companies with slower growth?"

    Yes, as I explain in this article:

    7 Stocks That Could Cause Permanent Losses, May 7, 2010,

    http://www.fool.com/investing/value/2010/05/07/7-stocks-that...

    My personal focus is asset allocation, so I am more concerned with valuing the overall market (or sectors) rather than individual stocks. The CAPE is superbly well suited to the former task.

    Nevertheless, the CAPE is based on a concept that Graham devised for individual stocks. In that regard -- for reasons I explain in a previous comment -- it is better suited to stable, mature companies.

    Alex Dumortier

  • Report this Comment On June 03, 2010, at 4:02 AM, cbaines2 wrote:

    Morgan, don't second guess your excellent analysis. Fools should be warned against putting their faith in a widely-known market prognostication tool. Investors aren't going to let the market get cheap enough by CAPE standards when the measure is so well-known. We don't know how CAPE will work when it is all over the blogosphere in a world where Schiller is regarded as a genius. Schiller was seen as an outcast when he first invented the measure (no one believed him in dot com days). Know that he and CAPE are so popular, I'm not so sure.

    Alex said something I found intriguing: "Looking at Robert Shiller's data, the 10-year average real earnings figure one uses to calculate the CAPE for the S&P 500 as of May 2010 is $54.86. Now, let's go back a bit to December 2006 -- before the credit crisis began and, thus, before AIG (NYSE: AIG) or any of the banks experienced significant mortgage-related losses. What was the equivalent average earnings figure then? $55.21 -- less than 1% higher than the current figure. In other words, these 'once or twice in a lifetime' losses have had virtually no impact on the average earnings used to calculate the CAPE."

    Holy smokes! This is looks like a WONDERFUL bull argument. We've been through hell and back and the 10-year average real earnings are the same as pre-recession (and even better if you don't factor in extraordinary AIG losses)? The Dow was at 12500+ in December 2006. Fundamentals have recovered but stocks haven't.

  • Report this Comment On June 03, 2010, at 4:45 AM, cbaines2 wrote:

    Something that I forgot to mention above...what really matters is not earnings but free cash flow. Companies don't go broke because they lack earnings, they go broke because they can't generate cash to meet their obligations. On the flip side, free cash flow is ultimately where dividend are born. Free cash flow (or a variant of it) is what Ben Graham's protege (Warren Buffett) uses, not earnings.

    So... where is the market today in terms of free cash flow? Better than pre-recession, at least for the non-financial blue chips that dominate the index. IBM, Pepsi, Coke, Microsoft, Colgate-Palmolive, and Kimberly-Clark are all generating more free cash flow than BEFORE the recession. In IBM's case, it is about 70% greater. In Kimberly-Clark's case, we see near record revenues, record net income, and record free cash flow. When you look at their cash flow statements, it almost makes you want to pause and ask "What recession?" Net income is grossly understating the true profitability of the dominant blue chips. The beauty of it is that they aren't being taxed on the basis of their free cash flow, but rather their net income. The free cash flow that exceeds income can effectively be distributed to shareholders without double taxation.

    So what, pray tell, about valuation? In Kimberly-Clark's case we see they are trading at only 10x free cash flow, a 10% real return assuming that free cash flow only grows at the rate of inflation. For the market as a whole it is hazier, because P/FCF is not widely published for aggregate markets. But what IS published is P/CF. Morningstar puts the TTM price-to-cash flow ratio of the S&P 500 at only 7. This is cheaper than any of the past 10 years, except 2008 (when it got to 6.8). After factoring in capex the P/FCF is going to be higher than the P/CF, but probably not THAT much higher. As is it, I believe the market is attractively valued, but only time will tell.

    Thank you,

    Chris Baines

    PS - Alex, I'm taking CFA Level 1 on Saturday. Wish me luck!

  • Report this Comment On June 03, 2010, at 5:14 AM, cbaines2 wrote:

    Something that I forgot to mention above...what really matters is not earnings but free cash flow. Companies don't go broke because they lack earnings, they go broke because they can't generate cash to meet their obligations. On the flip side, free cash flow is ultimately where dividend are born. Free cash flow (or a variant of it) is what Ben Graham's protege (Warren Buffett) uses, not earnings.

    So... where is the market today in terms of free cash flow? Better than pre-recession, at least for the non-financial blue chips that dominate the index. IBM, Pepsi, Coke, Microsoft, Colgate-Palmolive, and Kimberly-Clark are all generating more free cash flow than BEFORE the recession. In IBM's case, it is about 70% greater. In Kimberly-Clark's case, we see near record revenues, record net income, and record free cash flow. When you look at their cash flow statements, it almost makes you want to pause and ask "What recession?" Net income is grossly understating the true profitability of the dominant blue chips. The beauty of it is that they aren't being taxed on the basis of their free cash flow, but rather their net income. The free cash flow that exceeds income can effectively be distributed to shareholders without double taxation.

    So what, pray tell, about valuation? In Kimberly-Clark's case we see they are trading at only 10x free cash flow, a 10% real return assuming that free cash flow only grows at the rate of inflation. For the market as a whole it is hazier, because P/FCF is not widely published for aggregate markets. But what IS published is P/CF. Morningstar puts the TTM price-to-cash flow ratio of the S&P 500 at only 7. This is cheaper than any of the past 10 years, except 2008 (when it got to 6.8). After factoring in capex the P/FCF is going to be higher than the P/CF, but probably not THAT much higher. As is it, I believe the market is attractively valued, but only time will tell.

    Thank you,

    Chris Baines

    PS - Alex, I'm taking CFA Level 1 on Saturday. Wish me luck!

  • Report this Comment On June 03, 2010, at 6:16 AM, sarenjo wrote:

    Yes, trailing multiples are flawed - especially Shiller's 10-year trailer which is hurt by non-stationarity and other factors. I estimate that the market is looking for a 7.3% real return based upon current prices and earnings power, slightly ahead of the longer-term average and high given current interest rate levels. In my view, stocks are at worst fairly value and likely undervalued by some margin.

    I'm conducting research of how the stock market's volatility has impacted the asset mix of household investment portfolios over the past two years. The link below will take you to a brief survey. Once you have completed the survey, you will see a graphic of the average investor allocation at 3/31/2010.

    https://www.surveymonkey.com/s/investments1

    Thanks to the 500+ respondents that have completed the survey so far. Some interesting tidbits...

    1. A plurality of respondents report having an above average willingness to take investment risk.

    2. Less than half of respondents were net purchasers of equity over the past year.

    Please note: none of the questions ask for identifying information (e.g., name, social security #s, bank/brokerage accounts #s)

  • Report this Comment On June 03, 2010, at 1:09 PM, Glycomix wrote:

    Thank you for the education on CAPE.

    I am concerned about the following issues. I would appreciate anyone addressing them.

    Debt concerns me with Phillip Morris (PM) long term equity 300:1 and United Healthcare (UNH) LTEQ 28:1. These are high levels within their industries.

    Coors has good growth but some revenue problems. Sales are down 33% this year and down 25% from the sales of the first quarter in 2009; obviously they would also have growth problems too.

    Chevron is having a banner year in revenue, but has a dearth of projected growth. Perhaps its Gulf drilling being in limbo may be an issue? It also has slightly less debt than others in the industry, and it's the best in its class of US oil companies. My only question here is timing. Its price/action seems bearish right now on June 3, 2010. Wouldn't Chevron be a better choice to buy a little later when its on more of a sustained uptrend?

    Rayethon is a good value, although I'd like more than 5% growth. However, candlestick analysis suggests to me that it may be moving down after a jog up. Perhaps in a few days after today, June 3, might be a better time to buy this security?

  • Report this Comment On June 03, 2010, at 1:18 PM, Glycomix wrote:

    Coor's PE and debt are attractive, NOT its growth rate. Sorry for the doubletalk.

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