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Is the market overvalued or undervalued?

Are you bored with that question yet? I know, it can seem like a tired, worn-out question. But while it may make some folks roll their eyes in exasperation, this is a very important issue and has big implications for the returns you can expect from your portfolio.

Recently, one of the big debates has been over the use of price-to-earnings ratios based on one-year earnings -- either forward- or backward-looking -- versus using average earnings over the past decade. The group using the former metric will tell you that stocks are cheap; over the long term, the average one-year P/E has been just under 16 and the current one-year trailing P/E is 14.4.

The other group will tell you exactly the opposite, that is, that stocks are pricey right now. Over the long term, the average P/E based on average 10-year earnings -- also known as the "cyclically adjusted P/E," or just CAPE -- has been 16.4 and the current average-earnings P/E is 20.8.

Who's right?

Some historical perspective
History doesn't repeat, but it rhymes, right? To me, this means we should be able to get some perspective by looking back to find instances of these two valuation measures diverging.

Looking back to the turn of the century -- the 20th century, that is -- I was able to find a number of other times when the one-year P/E made stocks look much more attractive than the CAPE. The most recent also happened to be the most favorable for investors who are currently bullish. This happened in early 1995 and was followed by five years of outstanding returns.

However, the rest of the data isn't nearly as encouraging. Pretty much every other instance of this valuation-multiple divergence was followed by five years of mediocre returns (4% to 7% range) or even losses. Interestingly, my fellow Fool Alex Dumortier predicted yesterday that returns from U.S. stocks over the next 10 years won't exceed 7%.

If you flip the divergence on its head -- that is, look for times when the CAPE suggested that stocks were undervalued while the one-year P/E suggested that they were overvalued -- you would have done better. But historically the best times to invest were (drumroll, please!) when both the CAPE and the one-year P/E suggested that stocks were undervalued. No big surprise there.

Buy, sell, or fold?
The conclusion here isn't that you'll go broke by buying U.S. stock indexes. My view ends up similar to what Alex determined -- that overall U.S. equity returns will be pretty mediocre in the years ahead. If you've determined you don't need a return of more than 4% to 7%, then this shouldn't be much of a problem for you. However, if your retirement depends on a 12% annual return, there's a good chance you're going to be disappointed if you focus your investing on U.S. index funds.

But we're Fools. We want returns that exceed the overall market, and, for many of us, a 5% annual return isn't attractive.

One option in the search for better-than-average returns is to look for stocks that have lower-than-average valuations. Above, I noted that the best returns tended to follow periods when both the 10-year average P/E and the one-year P/E looked cheap. That may not be the situation the overall market is in right now, but there are definitely some individual companies we can find that fit that profile.

Earlier this month, I introduced five stocks that are very cheap on the basis of 10-year average earnings. Below are five more that fit the mold of looking cheap on both a one-year and 10-year P/E basis.


Price-to-Trailing Earnings Ratio

Price-to-Average 10-Year Earnings

Seagate Technology (NYSE: STX  )



General Electric (NYSE: GE  )



Aflac (NYSE: AFL  )



RadioShack (NYSE: RSH  )



L-3 Communications (NYSE: LLL  )



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

Of course, your work isn't done here. While there may be some more attractive valuations available when looking at individual stocks, more research is also required. An investor getting interested in Seagate, for instance, would want to dig into the data-storage industry and get comfortable with the shifting landscape there and how it impacts a major supplier of hard disk drives. Likewise, before investing in defense contractor L-3, you'd want to make sure you have a sense for how the government's budgetary issues may impact the programs that put dollars in L-3's pocket.

Generally, though, looking at valuations on both a current, one-year basis as well as a longer-term basis gives us a good starting point for finding stocks that may be able to top the market's (mediocre) returns.

Want to start keeping an eye on the cheap stocks above? Just click on the " " sign next to any of the tickers to add it to your watchlist. Don't have a watchlist yet? Click here to start one for free.

The Motley Fool owns shares of RadioShack, Aflac, and L-3 Communications Holdings. Motley Fool newsletter services have recommended buying shares of Aflac and L-3 Communications Holdings. 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 does not have a financial interest in any of the 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 Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Read/Post Comments (7) | Recommend This Article (16)

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 August 31, 2011, at 11:44 AM, ozzie wrote:

    The amazing thing about this list is that the 2nd-lowest CAPE, General Electric, is blazing trails in Energy, Aviation, Transportation, HealthCare, and is coming out of a huge slump in Financials.

    Once-upon-a-time, GE was the "If I could only pick 1 stock . . . " choice. Perhaps its that time again.

  • Report this Comment On August 31, 2011, at 1:07 PM, dctodd27 wrote:

    Matt -

    Youdaman. Good article. Spot on.

  • Report this Comment On August 31, 2011, at 2:09 PM, chopchop0 wrote:

    Too bad there is a distinct possibility that RSH won't be around in 10 years... It's amazing that you'd recommend it in this article for a long-term portfolio

  • Report this Comment On August 31, 2011, at 2:35 PM, TMFKopp wrote:


    There's the possibility of a lot of things happening over the next 10 years....

    Is there something in particular about RadioShack that turns you off? The company produces high returns, doesn't have a particularly threatening debt load...

    I admit that the business seems dated, but RadioShack stores always seem to have customers. It's like the cockroach of the electronics retail industry.


  • Report this Comment On August 31, 2011, at 9:22 PM, tuning50 wrote:

    RSH The cockroach that refuses to die. Thats funny but true. There are many HiTech families in rural areas and small towns whos kids are part of the and genre where RS is the only place in town to get parts for the robots and science fairs. Radio Shack has sensed this and signed on to the next generation's need for child geekyness selling micro-controller kits and piece/parts featured on these sites.

    Without RS and Harbor Freight, the next generation of garage inventors would be stalled.

    Hmm will Harbor Freight go IPO?

  • Report this Comment On September 01, 2011, at 7:57 PM, hbofbyu wrote:

    A long time ago I remember the Fool recommended shorting Guitar Center - primarily due to an expanding inventory and debt load. The clincher in their argument was that online competition and Walmart were going to take away their market. I bought the argument and put a little money on the short - which I quickly closed after I visited a Guitar Center. After seeing first hand I realized that there was no way a Walmart employee or an online site could provide the service and expertise (and cultural bonding) of the Guitar Center. The Stock kept going up and was aquired and taken private a few years ago. I learned a valuable lesson. Don't discount culture! Especially if you are not part of it or don't understand it.

    I'm confident Radio Shack will be around for a long time.

  • Report this Comment On September 02, 2011, at 10:37 AM, chopchop0 wrote:


    I see RSH as part of the consolidating B&M electronics sector. CC has died off and BBY sales have been lackluster despite that.

    Similar to what has happened with BKS after Borders died off

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