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Oscar Wilde once talked about the person who "knows the price of everything and the value of nothing."
After one of the most volatile months in modern history, investors are all too aware of the price of stocks. Their value, however, is another matter.
The history of markets is that of expensive markets becoming more expensive, and vice versa. Stocks spend very little time at the "average" that underpins most analysts' assumptions, creating a weird world where those who are probably right appear wrong most of the time. Accordingly, there will never be agreement on what the market is worth. But a couple of points might help guide your thinking.
The first is the spread between the earnings yield on the S&P 500 and 10-year Treasury bonds. The idea here is that stocks and bonds compete for investors' attention, so there should be a correlation between the two. The two assets have different characteristics -- stocks are perpetual; bonds have a terminal date -- but investors can be persuaded to ditch one in favor of the other if the price is right.
After the recent market turmoil, the spread between stock earnings and bond interest is now close to a 50-year high:
Sources: Yale University, author's calculations.
In clearer terms, the earnings yield on the S&P 500 is 7.5%, while a 10-year Treasury bond yields 2.1%. The 5.4-percentage-point difference is the widest gap since the early 1970s. Stocks, in other words, yield more than bonds by the largest amount in 40 years.
Whenever there's a big outlier like that, you should ask what the market is trying to say.
Current record-low bond yields hint at dismal economic growth, if not outright deflation. But on the contrary, stock earnings have been holding up remarkably well (so far). The discrepancy between the two is what's blowing open the spread. If the bond market is right, stock earnings might be poised to plunge.
An alternative explanation is that the current spread simply reflects panic. Record-low bond yields might not forecast slow growth as much as investors' determination to avoid the volatility of stocks while seeking the stability of bonds, returns be damned. If that's the case, it might bode well for stocks.
Others don't buy it. By at least one metric, stocks are still overvalued.
Yale economist Robert Shiller devised a way of valuing the market called the cyclically adjusted P/E ratio, or CAPE, which values the market with a 10-year average of earnings adjusted for inflation, which smooths out the noise of business cycles.
Since the 1950s (when the modern S&P 500 index was born), CAPE has averaged 19. Today it's at 19.5.
Sources: Yale University, author's calculations.
CAPE is hardly perfect. But it's probably the most no-bull way to value the market, immune to both forward-looking projections and short-term distortions caused by booms and busts. Benjamin Graham, Warren Buffett's early mentor, was one of the first to advise using a CAPE-like metric to value stocks. Doing so can be "useful for ironing out the frequent ups and downs of the business cycle," and can "give a better idea of the company's earnings power than the results of the latest year alone," he wrote.
By that logic, stocks might still be slightly overvalued at current prices. That doesn't mean they can't rally from here, but it gives ammo to those arguing that future returns might be meek at best.
What now?
None of this should suggest that you either go hog wild with, or bail out on, stocks. Instead, current valuations, far from being obviously cheap or obviously overvalued, stress the importance of smart stock picking.
While broad market indices might look questionable, average valuations on high-quality large-cap stocks provide opportunities for what look like reasonable bets. The average S&P 500 company trades at nearly 15 times earnings, yet for the 80 largest names, the average is less than 12 times earnings. This underscores something we've been banging on about for the past two years: If there's value in today's market, it's in high-quality giants -- names like Microsoft (Nasdaq: MSFT ) , Johnson & Johnson (NYSE: JNJ ) , Intel (Nasdaq: INTC ) , and Wal-Mart (NYSE: WMT ) . All are above-average companies selling for below-average valuations.
Ah, value! So much more useful to discuss than price.
For more ideas on cheap, high-quality companies, check out The Motley Fool's free report 13 High-Yielding Stocks to Buy Today. Just click here. It's free.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.
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Report this Comment On August 23, 2011, at 12:45 PM, jpdal09 wrote:
Great article Morgan
Now here's my question, for awhile I've been reading articles on valuing stocks in trying to be able to estimate the underlying value of stocks for myself. So, in your opinion, what's the most accurate metric for measuring value? P/E, EV/FCF, EV/EBITDA, or another one? Or maybe it's a combination of them one has to use to find an accurate value of a stock? Do these metrics measure different facets of a company? Am I just confused, turned around and upsidedown??
Report this Comment On August 23, 2011, at 12:48 PM, TMFHousel wrote:
^ It really is case by case, but I've always loved unlevered FCF over enterprise value.
--Morgan
Report this Comment On August 23, 2011, at 3:26 PM, pondee619 wrote:
"The 5.4-percentage-point difference is the widest gap since the early 1970s. " Perhaps if you could overlay a chart of a major index during over the spread chart above we could see if there were any effect on stocks. How were stocks doing in the early 70's? Could we exect a similar reaction today? Why, or why not?
" CAPE has averaged 19. Today it's at 19.5." Wouldn't that tell us that stocks are fairly valued? Is that half point really significant?
"and Wal-Mart (NYSE: WFMT)" What is the ticker for Wal-Mart?
"... All are above-average companies selling for below-average valuations." Your ticker cites do not provide historic PE ratios. Wouldn't it then have been a good idea to provide them for our review?
Someday we will get a complete story from the fool. I would prefer a quality, complete story rather the the dozens per day to sift through.
Report this Comment On August 23, 2011, at 5:30 PM, jimmy4040 wrote:
Oh brother! How many "you can't time the market" columns must we have here, only to be followed by subliminal "you CAN time the market" ones such as this.
Also if you use historic price data in evaluating a stock, you will have dozens of responses saying that it doesn't matter (see MSFT for instance). However any OTHER historic metric BUT price apparently matters a great deal.
Report this Comment On August 23, 2011, at 5:44 PM, TMFHousel wrote:
^ Buying based off value is far different than market timing. Someone who buys based on value isn't predicting when a stock might gain; only that it is likely to at some point.
Report this Comment On August 23, 2011, at 9:31 PM, HomieDontMess wrote:
Awesome article. I am definitely looking to add to my MSFT and INTC positions.
BTW, if you were 22 and single with a steady income, would you make a moderate gamble on BAC? I have been toying with the idea and each day it falls I find it tougher to not pull the trigger.
Report this Comment On August 23, 2011, at 9:57 PM, TimothyVR wrote:
Good article. I appreciate the inclusion of both the spread between stock an bond yields as well as the CAPE.
We have also seen a significant drop in the CAPE in recent weeks. After many months in the range of 23-24, it has dropped about four points. Another drop of that magnitude would suggest that we are starting to move into the undervalued territory even by that standard.
And as you point out there are plenty of high quality dividend payers that were have not been overvalued for many years are now very attractively priced.
Report this Comment On August 23, 2011, at 9:58 PM, jimmy4040 wrote:
Home:
BAC is a bad story for any age. The fact that it may survive does not mean that there aren't much better investments out there. Look at it this way. Wouldn't any environment that caused BAC to prosper, cause better financials to accelerate even faster?
Report this Comment On August 23, 2011, at 10:34 PM, Knightmare535 wrote:
On the topic of trying to calculate value (and be lazy at the same time), Quicken used to have a site with a screen that you could set different parameters, methods and time-value amounts on and it would screen for intrinsic value, based on the way you wanted to calculate it. That site is gone now.
Does anyone have a good screen for calculating intrinsic value? I found it was a great starting point.
Report this Comment On August 23, 2011, at 11:35 PM, 11x wrote:
I wouldn't tak a "moderate gamble" on ANY stock no matter what my situation is. "Moderate gamble" indicates you do not have an understanding of the situation.
You may as well be saying: Since I have extra cash should I throw money at BAC, even though I have not researched it, and therefore likely to make emotional buy/sell decisions?
Report this Comment On August 24, 2011, at 12:13 AM, jamison777 wrote:
"Current record-low bond yields hint at dismal economic growth, if not outright deflation."
The fact that GDP has been shrinking for 3 consecutive quarters, and keeps getting revised downward also screams dismal economic growth. A 20.06 PE (where we're at after today's rise) is extremely high during a period of contracting growth. I am not looking at stocks here. At best we go sideways for 3-5 years. At worst?
Everyone keeps talking about "buying with blood in the streets"... but the problem is, there isn't any. Everywhere I look people are calling this downturn a "buying opportunity". That usually means the selling is far from over. If you truly want to buy where there's blood, you look at real estate here. Mortgage rates are now at 50 year lows, and sellers are downright desperate.
Report this Comment On August 24, 2011, at 1:50 AM, n4g4 wrote:
Great article. It doesn't push either way, just gives you information. That is all I really need, unbiased information. I can make my own choice to buy or sell.
The market rally today was based on... hope? Yeah, I definitely want to buy into a rally based on something that rational. Ben should go to Jackson Hole every week. The constant tinkering is only going to make it take longer to get on a solid foundation.
Report this Comment On August 24, 2011, at 3:41 AM, 11x wrote:
I don't think the rally today had anything with Bernanke going to Jackson Hole. This has been planned for a long time. Every day, journalists are tasked with explaining why the market went up or down.
Report this Comment On August 24, 2011, at 11:36 AM, ayaghsizian wrote:
Opinions on BAC? It is getting cheap, but how do you value an unknown future?
Report this Comment On August 25, 2011, at 9:29 PM, JacobFFDR wrote:
Funny to read the comments about BAC that were written before today. Anyone end up buying before today's 10% Buffet-rally??
Report this Comment On August 26, 2011, at 1:55 PM, ayaghsizian wrote:
When it was 6.90 I considered buying puts thinking it would drop back to 6.40. Lucky i didn't.
Report this Comment On August 28, 2011, at 3:15 PM, spyde wrote:
"Funny to read the comments about BAC that were written before today. Anyone end up buying before today's 10% Buffet-rally??"
I did good sir at $6.91. Too bad I didn't wait until it went down 8% from there.
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