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Staring Trouble in the Face

If there's something bigger than a bull market, it just happened.

The S&P 500 officially doubled from its March 2009 lows last week. This was the fastest the index has ever doubled since its debut in the 1950s. Markets have surged 25% over the past six months alone -- essentially uninterrupted, mind you. This stuff makes the late '90s look dull.

Seems like a good a time to check on valuations.

This chart helps me put the S&P's valuation into context:

Sources: Standard & Poor's, Yahoo! Finance, author's calculations.

Markets traded at these levels in mid 2006. The S&P 500 earned $88 that year. It's forecast to earn $96 this year after pulling in $84 in 2010.

Investing in mid-2006 wasn't, of course, a brightest of moves. The market rallied over the following year, then ate dirt for the next two. The big reason markets collapsed from 2007-2009 was the financial crisis -- not high valuations per se -- but this is almost an irrelevant distinction. Investors were burned when the financial crisis hit from 2007 on because valuations didn't leave any room for the economy's inevitable hiccups. There was no margin of safety. No cushion. The best you could hope for was mediocrity. Maybe a little more, probably a lot less -- which is what happened.

Today's market is starting to look similar. On a trailing-12-months basis, the S&P trades at 16 times earnings, versus an average of about 18 over the past 23 years. Ignore the insane valuations of the late '90s, and today's valuations are probably about historically average. Use a different metric, like Yale economist Robert Shiller's cyclically adjusted PE ratio, and today's market looks somewhat above average. Balance that out with today's record low interest rates, and I'm throwing my weight behind today's market being averagely valued. Final answer. I've held out for a long while, convinced that broad markets still looked cheap. Not anymore. The facts have changed. Normal valuations are back.

What's that mean? Just what it meant in 2006. The best we can now hope for is middling long-term returns -- 5%-7% per year, something like that. That's not being pessimistic. It's just what happens when valuations rise.

But here's what should make you pessimistic: With valuations where they are, it'll get real itchy once another of the economy's inevitable hiccups rears its head. Inflation. Rising interest rates. Geopolitical tension. Foreign uprisings. Partisan clown shows. Corporate fraud. Bieber Fever. Go right down the list. When one of these events comes along, there's no cushion in stock valuations to muffle the blow like there's been over the past two years. No more margin of safety. Just you, staring capitalism in the face. That's when investors set themselves up for trouble.

This doesn't mean you should abandon stocks. It doesn't mean panic. It just means you have to get more selective. Broad markets might look hairy, but plenty of individual companies still look great. Microsoft (NYSE: MSFT  ) is doing a lot of things right, and trades at less than 10 times forward earnings. Nice. Johnson & Johnson (NYSE: JNJ  ) is mired in the negative publicity of recall after recall; its stock trades at less than 12 times forward earnings and delivers a 3.6% dividend. Exploit that.

If inflation's got you worried, those with a strong history of pricing power, like Altria (NYSE: MO  ) and ExxonMobil (NYSE: XOM  ) , will do you well. Another interesting idea: Several of the world's greatest investors piled over the last quarter into the newly listed shares of General Motors (NYSE: GM  ) , now leaner and meaner than it's been in years. If you're bold and think the hysterics are overblown, check out municipal bond funds. After falling precipitously over the past few months, some now yield over 8%.

Opportunities still exist. Just not where it's been over the past two years.  

What do you think?

Fool contributor Morgan Housel owns shares of Microsoft, Johnson & Johnson, Altria, and ExxonMobil. General Motors and Microsoft are Motley Fool Inside Value selections. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Altria Group, Exxon Mobil, and Microsoft. 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. The Motley Fool has a disclosure policy.

Read/Post Comments (13) | Recommend This Article (34)

Comments from our Foolish Readers

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 22, 2011, at 5:30 PM, xetn wrote:
  • Report this Comment On February 22, 2011, at 5:42 PM, xetn wrote:
  • Report this Comment On February 22, 2011, at 7:16 PM, fusionfactory wrote:

    I love the spam to buy junk in the comments. It so completely finishes the point of the article.

  • Report this Comment On February 22, 2011, at 7:27 PM, CMFStan8331 wrote:

    The market has climbed the ladder very quickly, and I do see the possibility of a significant pull-back sometime this year. However, I don't believe that we have to be resigned to slow growth in the next few years.

    I think we can reasonably expect much stronger earnings going forward from here than we should have expected back in 2006, because companies have gotten far leaner than they were five years ago. We've seen widespread reduction and/or mitigation of debt, combined with extreme caution in new hiring that has caused great anxiety throughout the country. Those factors should make it a lot easier for companies to ride out near-term volatility, and avoid sending us back down toward the March 2009 range or below.

    If we can avoid another destructive crash, I believe the market will continue to trend significantly higher from here over the next few years.

  • Report this Comment On February 22, 2011, at 7:42 PM, schoenyman wrote:

    I am concerned about the economy as a whole. I haven't found anything on the Fool about the terrible debt problems confronting us. The state and federal governments are in trouble. I'm from WI and our governor is trying to some how do something about it. No concern for investors? I am very worried and am thinking of selling and putting my money in a jar in the back yard. Would the Fool comment? People here, except for this writer, seem to have their collective heads in the sand.

  • Report this Comment On February 22, 2011, at 8:09 PM, jargonific wrote:

    Get rid of the short selling system and markets will attain top performance. The economy will also recover more quickly and with more certainty when short sell tag teams are no longer able to push the best performing stocks down to suit their option trading whims.

    The French are regulating short selling. Where US regulators did investigate inside trading they found heavy use of the internet to coordinate purchases and sales so that stocks would be forced into line with the investor's option trading, so that a top stock would be pushed down and investors could then profit on repeated increases.

    Americans and their German partners have to regulate short selling for markets to recover. Period. This goes for the markets with or without the pressure of MidEast uprisings.

  • Report this Comment On February 22, 2011, at 8:11 PM, cmfhousel wrote:

    "Get rid of the short selling system and markets will attain top performance. "

    Interestingly, China banned short selling altogether, and its market still managed to crash in 2008.

  • Report this Comment On February 22, 2011, at 10:11 PM, inkstainedwretch wrote:

    "Interestingly, China banned short selling altogether, and its market still managed to crash in 2008."

    Your point? I take vitamin C during cold season, but I don't expect it to help if I'm hit by a bus.

    A ban on short selling won't prevent crashes, but it might make the market more stable.

  • Report this Comment On February 22, 2011, at 10:17 PM, 19Patrick58 wrote:

    The market is roaring, true. But 14.9 million Americans don't have jobs, and another 10.7 million are working in part time jobs for economic reasons or have simply given up. Our labor force participation rate is down to 64.2% from 64.8% in Jan. 10. 1 in 4 Americans are working temporary or contingent jobs with low pay, no security and no benefits. IN addition, many local governments will be going bankrupt, and are even now deferring maintenance on the infrastucture businesses depend on for predictability and profitability. Wisconsin, Indiana and Ohio are in revolt. I know many of your are conservative, but we seem to have forgotten what Henry Ford knew; if you don't pay people enough to buy your stuff, you won't sell any stuff. Many voices in DC are crying out for draconian austerity measures. I remind you all how fragile our recovery yet is, and say that we truly are in danger of a substantial reversal.

  • Report this Comment On February 23, 2011, at 2:22 AM, TMFAleph1 wrote:

    <<Get rid of the short selling system and markets will attain top performance. The economy will also recover more quickly and with more certainty when short sell tag teams are no longer able to push the best performing stocks down to suit their option trading whims.>>

    I'm not sure how you define "top performance", but I'm absolutely certain that banning short selling would have not impact whatsoever with regard to helping the economy recover more quickly.

    Alex Dumortier

    Alex Dumortier

  • Report this Comment On February 23, 2011, at 2:27 AM, daveandrae wrote:

    The direction of the next 20% move in the stock market is completely unknowable. Don't put any energy into.

    Completely capturing the direction of next 100% move is that which is most important. And we all know which direction that is going to be. Now don't we?

    One will be far better off in the long run putting their energy into things which they have some control. Like Faith, Patience, and Discipline. Everything else, in my opinion, is nothing more than commentary.

    Buy Equities- HOLD equities.

    Nuff said

  • Report this Comment On February 23, 2011, at 3:24 PM, manz9 wrote:

    I agree with the author oppurtunity always exists but i think people are getting dangerously greedy, these kind of corrections are healthy for all. good luck


  • Report this Comment On February 23, 2011, at 4:06 PM, Merton123 wrote:

    There is a lot of good news that is not being broadcasted since it doesn't in the minds of the financial media generate readership. A large middle class is beginning to emerge in China, India, and Eastern Europe. The foreign companies that provide goods and services to these markets will continue to enjoy great earnings growth. The difference in the earnings growth rate of foreign versus American Companies is the reason in my opinion that Vanguard total world index will soon replace Vanguard S&P 500 index as the best index to be in for total returns for the next 20 years.

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