As the Market Hits a New High, So Does Risk

The Dow Jones Industrial Average and the S&P 500 both achieved new highs for 2009 yesterday. As my colleague Morgan Housel wrote last Friday, optimism is back! Splendid news for stock investors, indeed … or not. Would it surprise you to learn that it is much riskier to buy U.S. stocks now than it was at the beginning of March, when fear and panic were at their highs?

It comes down to valuation (as always)
The reason? Price. At yesterday's closing value of 1,028, the S&P 500 is trading at 18.4 times its cyclically-adjusted earnings (average inflation-adjusted earnings over the prior 10 years). That is a 12% premium to the multiple's long-term average going back nearly 130 years.

The cyclically-adjusted P/E ratio -- or CAPE -- was originally pioneered by investing legend Ben Graham. It is one of the only indicators that has consistently proved its worth in identifying whether the U.S. stock market is significantly over- or undervalued.

Why pay a premium now?
Under normal circumstances, a 12% premium wouldn't really be troublesome. However, when one factors in the (high) likelihood of a protracted, weak economic recovery, any premium is problematic. By contrast, on March 9th, the date on which the stock market hit its crisis low, one could have "purchased" the S&P 500 for just 11.8 times cyclically-adjusted earnings -- a 28% discount to the long-term average. (For the skeptics: One could have derived this figure at the time -- the CAPE isn't just useful in hindsight.)

The increase in the earnings multiple is even more striking for some individual stocks (these one-year forward earnings multiples must be treated with caution -- they do not necessarily imply that any of these stocks are overvalued):

Stock

Forward P/E (Next
12 Months EPS Estimate)

Forward P/E on
March 9, 2009

% Stock Price Return
Since March 9 Market Low

JPMorgan Chase
(NYSE: JPM  )

18.8

9.6

174%

Apple
(Nasdaq: AAPL  )

26.1

16.5

104%

General Electric
(NYSE: GE  )

18.0

6.0

93%

Microsoft
(Nasdaq: MSFT  )

14.3

8.5

63%

Cisco Systems
(Nasdaq: CSCO  )

18.4

12.8

62%

Google
(Nasdaq: GOOG  )

20.5

13.8

62%

Procter & Gamble
(NYSE: PG  )

14.7

11.6

21%

Granted, the outlook then and now isn't exactly the same, but, despite being nearer the end of the recession, the world hasn't changed all that much in the last five and a half months -- certainly nowhere near enough to warrant the CAPE's current premium to its historical average. That investors should be more excited to buy stocks at current prices defies rationality.

What's an investor to do?
I've warned repeatedly in recent weeks that the market is overvalued and that we should, therefore, expect a correction. Investors with broad exposure to U.S. stocks should consider rebalancing their exposure with a keen eye to valuation. High-quality companies are one alternative, international stocks are another.

Jeremy Grantham's firm, GMO, is forecasting that "high-quality" U.S. stocks will beat large-cap stocks by more than six percentage points annually over the next seven years! Morgan Housel has identified three high-quality companies that are still cheap.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality company stocks trading at reasonable prices. To find out their top five recommendations for new money now, take advantage of a 30-day free trial today.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Google is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor pick. Microsoft is a Motley Fool Inside Value recommendation. Procter & Gamble is a Motley Fool Income Investor pick. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (9)

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 26, 2009, at 4:03 PM, scagman wrote:

    Is there a way to track the real time CAPE on a daily, weekly or monthly basis? I've often wanted to do this but have had trouble finding any info that isn't six months old.

  • Report this Comment On August 26, 2009, at 8:09 PM, TMFAleph1 wrote:

    scagman,

    Thanks for your interest.

    Check out the spreadsheet that is compiled and maintained by Robert Shiller, which will allow you to track the CAPE on a daily basis. The spreadsheet is available at:

    http://www.econ.yale.edu/~shiller/data.htm

    Regards,

    Alex Dumortier (TMFMarathonMan)

  • Report this Comment On August 27, 2009, at 12:29 PM, scagman wrote:

    Thanks Alex, and great article.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 972090, ~/Articles/ArticleHandler.aspx, 10/26/2014 1:38:16 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement