How Long Should You Ride This Rally?

Pop quiz, hotshot: The S&P is up more than 60% from its closing low last March. If the market continues to go up, you want to ride along with it. But if it reverses course, you want to protect your nest egg. So what do you do?

The answer seems obvious, right? U.S. unemployment is still close to double digits, banks like JPMorgan Chase and Bank of America have shown that their consumer and commercial lending businesses are still getting beaten up, and government spending is propping up the economy. It's time to sell!

But wait just a second there. Earnings reports from the likes of Apple (Nasdaq: AAPL  ) , Whole Foods (Nasdaq: WFMI  ) , and Deere (NYSE: DE  ) seem to show the light at the end of the tunnel; home sales appear to finally be showing signs of stabilization; and many economists seem confident that the recession is over and the U.S. is returning to growth. For Pete's sake, buy!

Don't mind the 60%
Stock market commentators tend to be a rather fearful bunch. When times get bad and the market is sinking, many of them seem to suffer from taphephobia -- a fear of getting buried alive -- and they want to run for the hills as quickly as possible. On the flip side, when the market is shooting up, acrophobia -- the fear of heights -- seems to come into play and, well, they're off running for the hills again.

But if you ask me – or, really, any fundamentals-oriented investor -- our concern shouldn't be how much the market has gone up or down, but rather whether its valuation is attractive or unattractive. If a hot market with sky-high valuations rises 60%, that acrophobia is probably warranted. On the other hand, if a sorely undervalued market tacks on that same 60%, there could still be good reason to buy. 

Do mind the valuation
There are many ways to track the market's valuation, but I'm a big fan of the work that Robert Shiller of Yale has done. He maintains a spreadsheet that tracks the S&P's price and earnings going all the way back to 1871 and tracks the market's valuation by comparing price with the average earnings over the past 10 years.

The long-term average P/E ratio is around 16.4. The current readout is a hair over 20, which is up from 13.3 in March and down from 27 prior to the market's crash. So today's valuation isn't nearly as attractive as March's, but it's more attractive than what was available to us before the recession.

What's concerning, though, is that earnings estimates for the S&P index from Standard & Poor's suggest that earnings will remain below their prerecession levels. This means that even if the market doesn't move up much more, its valuation will stay high as earnings plod along.

And if you want to try to escape this escalating valuation by moving back to a P/E based on a single year of earnings, don't bother -- earnings are expected to be low enough that the single-year P/E may be well over its historical average through the end of 2010, even if the S&P's price doesn't budge from today's level. 

So what do you do?
Back in March of last year, when the market's valuation was undeniably low, it was difficult to go wrong with buying an index fund and calling it a day. Sure, you could have done better buying certain individual stocks such as Capital One Financial (NYSE: COF  ) (up 322%) or Dow Chemical (NYSE: DOW  ) (up 354%), but you would have done quite well with an index and wouldn't have had to break much of a mental sweat.

If you're a long-term retirement investor and you want to keep it simple, you still may be OK grabbing those index funds today. For investors who like to put on a hard hat and go prospecting for the best stock opportunities, though, now is a good time to start eschewing the index funds in favor of individual stocks that are still undervalued. 

CVS Caremark (NYSE: CVS  ) , for example, is still trading at 11.4 times its expected 2010 earnings, which is much more attractive than the broad S&P index. Database giant Oracle (Nasdaq: ORCL  ) , meanwhile, is sitting at an attractive forward P/E of 14.2.

And while I think the stocks of those blue-chip candidates could perform quite well, there may be even more opportunity for investors willing to consider small-cap stocks. The world of small caps is a largely uncharted sea of stocks that most institutional types avoid because they're too small to make an impact on huge mutual fund portfolios. For individual investors, though, they can be a great way to find hidden value -- particularly at the outset of an economic recovery.

If you're looking for stock ideas, the advisors at Motley Fool Hidden Gems are a great resource for new or veteran small-cap hunters. You can see their six Buy First stocks and read the research on all of their recommendations free for 30 days. Click here to get started.  

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned in this article. Apple and Whole Foods are Motley Fool Stock Advisor recommendations. The Fool owns shares of Oracle. The Fool's disclosure policy enjoyed Speed in spite of Keanu Reeves.


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