Are Valuations Too High?

For long-term investors, pondering the question "Will the market go up?" is a guilty pleasure, like gorging on In-N-Out double-doubles. And yet we still do it. OK, maybe you don't, but I do (both, actually).

A key component to this question is whether stocks are overvalued, undervalued, or reasonably valued. If the answer is "undervalued," we can feel pretty good about being buyers, while if they're reasonably valued selective stock-picking can usually uncover some bargains.

But if stocks are overvalued, that's a problem. Finding worthwhile investments becomes more difficult and there's a greater chance that the entire market will sink.

So what's the story right now?

This time it's ... different?
Investing life would be a lot easier if it were a snap to figure out whether the market is over- or undervalued. But alas, it's not.

In support of the "undervalued" thesis, we can look at the fact that high-quality franchises like Chevron (NYSE: CVX  ) and JPMorgan Chase (NYSE: JPM  ) are trading at less than 10 times forward earnings. To be sure, there are questions over how long the price of oil will stay up and just how healthy the financial sector really is, but those are still eye-catchingly low valuations.

At the same time, the price-to-earnings ratio on the S&P 500 is 16.7, which is below the average of 22.5 during the period between 1988 and today.

But what keeps bugging me is the fact that the CAPE -- that is, the cyclically adjusted price-to-earnings ratio, which is a valuation measure that uses average earnings over a 10-year period -- is well above its historical average. The bull in me would like to respond to that by saying that valuations in the late 1800s -- which is where the data begins -- aren't useful in 2011. But I think a simple picture tells us all we really need to know.



Source: Irrationalexuberance.com.

This chart tells a pretty clear story: Stock valuations as measured by the CAPE have, over time, revolved pretty consistently around the long-term average. That strongly suggests that the massive deviation that took place in the 1990s and the first decade of this millennium is still adjusting and will likely lead to a period of lower valuations. To suggest otherwise would be to utter the classic "It's different this time" -- a phrase that never fails to make me uneasy.

And for those that are unsure about this "CAPE" gibberish, the picture looks very similar if we switch to single-year price-to-earnings ratios.

Source: Irrationalexuberance.com, Standard & Poor's, author's calculations.

And the moral of this story? Investors should be particularly conscious of valuations and wary of getting too complacent. Putting an exact timeline on when valuations will adjust downward is a difficult (if not impossible) proposition, but I am not fond of betting against mean reversions like this.

Chevron is a Motley Fool Income Investor selection. The Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Chevron, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 04, 2011, at 4:13 PM, pbk100 wrote:

    One thing that neither P/E nor CAPE capture is the amount of cash or debt companies carry, and while I'm not sure of aggregate figures, right now a lot of the large companies I've looked at carry historically high levels of cash. Just as EV can be more useful than P for determining if an individual stock is over- or under-valued, it would seem to make more sense to adjust broad-market stats in a similar way.

  • Report this Comment On February 04, 2011, at 9:58 PM, NovaB wrote:

    I think somehow the models got broken when "globalization" took the local (United States) economy over. The curves are meaningless if in 1980 you spoke of manufacturing being almost all north American and now manufacturing is China-centric.

    In 1982 an economics professor I knew told me the administration had broken the economic models by ignoring the rules. They had pulled the cork from the bottle put in by the liberals trying to hamstring business, especially the banks, in the 1930s. Call it deregulation in its simplest form. He also said forces would make sure the cork could never be replaced.

    How do we put things back into a context that makes sense comparing then and now? We need new models.

  • Report this Comment On February 05, 2011, at 9:23 AM, FutureMonkey wrote:

    As you say at the onset, predicting the direction of large scale market valuations can be challenging.

    One thing to consider beyond traditional metrics of valuation, is where else are people, businesses, institutions going to put their "investment" dollars. If not in equity markets where? Bonds, Commodities, Currency, Real Estate, Derivatives, Tulip Bulbs?

    I don't know where the big money was kept during the long term secular bear markets when CAPE was below the 16.4 long term average.

    Seems to me one of the major shifts in market theory since the 70's is the advent of very very large sums of money in mutual funds and wide access of general population to equity markets. My preception is that alternatives to equities are less appealing to both small and large scale investing.

    Unless another market emerges as a long term "smart money" investment rather than short term speculative shifts, I suspect that we will continue to see tremendous volitility but continued valuations above the 16.4 mark we bounced off of in 2008/09

  • Report this Comment On February 05, 2011, at 9:40 AM, daveandrae wrote:

    Anytime you can purchase a small piece of a quality business like Merck at less than 11 times its five year average earnings when ten year bond yields are less than 4%, equity investing makes sense.

    At these market prices, the Merck investor is accruing roughly 5% more, per year, in earnings power, than the bond holder is getting in Interest income.

    Over a ten year holding period, the annualized compounding of this aggregate purchasing power will have offset all of the vicissitudes of what will surely be a gyrating stock market.

    This is why you don't need much insight or foresight to be successful when buying common stocks.

    Everything else, in my opinion, is "noise". I have no idea, nor do I care, what those "charts" mean, or say. I have idea, or control, of what the general stock market is going to do "next." Thus, why put any energy into it.

    Thomas Edmonds

  • Report this Comment On February 05, 2011, at 10:46 PM, MartinSamuelson wrote:

    A high CAPE could mean current prices are historically high... but it could also mean earnings have been historically low, which wouldn't be surprising considering two (major) recessions have occurred in the past 10 years.

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