Is the SPDR S&P 500 a Buy?

In the stock market, extended periods of below-average returns usher in periods of above-average returns, and the '00s were one of the worst decades ever for stocks. The rebound in corporate profits as we exit the recession has been remarkable. Finally, interest rates look likely to remain exceptionally low into next year. Surely now is the time to grab a ticket on what is bound to be a powerful bull market, by purchasing shares of the SPDR S&P 500 ETF (NYSE: SPY), which tracks the popular market index.

Unfortunately, a clear-headed assessment of the data doesn't support buying the S&P 500 just yet, despite the correction that began in May. But don't despair; I'll suggest some other choices for your investing dollars.

No longer cheap -- even after the correction
Low-return periods precede high-return periods because they produce significantly discounted stock valuations. The S&P 500's cyclically adjusted P/E (CAPE) multiple, which is based on a moving average of earnings over the previous 10 years, bottomed out just below 12 on March 9, 2009, compared with a long-term average of 16.3. March 2009 was clearly a buying opportunity, but we've had our cyclical bull market since then and right now the CAPE is close to 20, which is anything but "value" territory.

What kind of returns can investors expect from the S&P 500? Asset manager GMO forecast on April 30, 2010, that large-cap U.S. stocks would generate an annualized real return (i.e., after inflation) of just 0.2% over the next seven years. Why listen to GMO? They use a systematic, rational framework to derive their estimates; they were one of the few market participants in 2000 forecasting a negative total return on stocks over the next decade.

Sub-2% returns look likely
GMO established their forecast on April 30, with the S&P 500 9% above its current level. Adjusting their estimate for the decline in stock prices that has occurred since then adds 1.1% (lower prices imply better returns), for a revised estimate of 1.3% (annualized real return). That remains a mediocre return for stocks, well below their historical long-term average return of 6.5%.

My conclusion: Don't listen to those who say the recent correction is a buying opportunity; we simply haven't reached those levels yet. Stocks may well get back to fair value (or below!), and the market has made some headway in that direction, but it makes no sense to be overweight the broad U.S. market right now, particularly when there are more attractive alternatives.

An alternative to U.S. stocks
Emerging markets, for example, look like they will offer better returns over the long term, while superior growth prospects and public finances that put many advanced economies to shame mitigate some of the risks traditionally associated with investing in these markets.

If you are interested in ETFs (I assume you are since you're reading an article about SPY), I recommend the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) and the Vanguard Emerging Markets ETF (NYSE: VWO). Both ETFs track the MSCI Emerging Markets Index, but I prefer the Vanguard ETF because its expense ratio (0.27%) is nearly two-thirds less than that of the iShares product (0.72%).

Looking for value in individual stocks
If you prefer to invest in single stocks, there are certainly pockets of value within the U.S. market. Large-cap blue-chip stocks look relatively attractive, for example. These are companies that have built tremendous franchises, have low debt, and enjoy stable cash flows -- all highly desirable characteristics in an economic environment that still contains many risks. The following table highlights four such stocks:

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

Don't be early on the SPY; patience pays
The S&P 500 ETF is a terrific way to own broad U.S. market exposure. However, just as with individual stocks, paying above fair value for this fund is unlikely to produce a happy result. Investors who are interested in owning this ETF should remain patient. There are plenty of potential catalysts for a deeper correction that would bring the S&P 500 back to a suitable "buy" range. Failing that, they should investigate other options such as the ones I have described above.

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.