Earn Fat Returns Beyond the Rally

The 2009 stock market rally off March lows was remarkable for its strength and its breadth. Nearly six in 10 stocks (58%) in the S&P 500 outperformed the index on a price return basis in 2009. For many investors, just showing up (i.e., being invested) was good enough to "place" last year. While we're unlikely to witness a repeat of that this year, today's market presents real opportunity for a specific set of investors. Let me tell you who these investors are and why their performance won't depend on whether or not this rally will continue.

It just ain't cheap anymore
As I've pointed out multiple times on this website, the U.S. stock market is now fully valued at best. According to data compiled by Robert Shiller of Yale, the S&P 500's cyclically adjusted P/E (CAPE) is now 20.3%-24% above the long-term average for the multiple going back to 1871 (the CAPE is calculated based on average real earnings over the prior 10 years). That presents a degree of risk for stock investors, particularly those who are broadly invested via index funds such as the SPDRs S&P 500 ETF (NYSE: SPY).

All overvalued markets aren't created equal
"Overvalued" doesn't tell the whole story, however. There are two ways in which the stock market can be overvalued, that I refer to as "overvalued in aggregate" and "broadly overvalued":

• Overvalued in aggregate: The index is overvalued, but the range of stock valuations is wide enough to accommodate stocks that are overvalued as well as stocks that are undervalued.

• Broadly overvalued: The index is overvalued and so is nearly every stock. In this case, there are typically two types of stocks: overvalued and insanely overvalued.

From the lows last March, we've gone from a market that was broadly undervalued (nearly everything was cheap -- a prime buying opportunity) to one which is now overvalued in aggregate; i.e., on the whole, the market is expensive, but some stocks remain undervalued (or fairly valued).

The following table gives us some notion of how stocks in the S&P 500 have changed over the last nine months, in terms of the distribution of their valuations:

*Forward P/E based on the next fiscal year's estimated earnings per share.
Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

The standard deviation is a measure of the range within which the stock P/E multiples are spread out around their average. That range has increased across the entire index and within nearly all sector groups. For example, the range of P/Es for Materials stocks has ballooned, as the following six-stock sample shows:

*Forward P/E based on the next fiscal year's estimated earnings per share.
Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

As the range of stock price multiples has widened, this suggests we are in a market in which (proficient) stock pickers will be rewarded, as judicious stock selection can add substantial value. Being able to hone in on stocks that are undervalued and throw out those that are overvalued will be critical to investment success this year.

It's all about value
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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Monsanto is a Motley Fool Inside Value pick. The Motley Fool has a disclosure policy.