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Is the Stock Market Cheap or Not?!

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The last thing any investor wants to do is to buy stocks when they're expensive. But when two of the most experienced academicians in the field of market analysis can only butt heads repeatedly over what seems like the simplest way possible to evaluate stocks, you know you've got a mind-bender on your hands. But it's a mind-bender worth solving -- because the answer could make a huge difference in your long-term investing results going forward.

The great debate
At the heart of the controversy over stock valuations is how to evaluate earnings for purposes of calculating a price-to-earnings ratio. In one corner is Wharton professor and market historian Jeremy Siegel, who spoke at TD AMERITRADE Institutional's annual conference yesterday. Siegel believes that stocks are undervalued, looking at the current P/E ratio for the S&P 500 and concluding that the market should be about 20% higher assuming a normal rate of inflation going forward. If low inflation continues, Siegel sees a much more bullish target above 2,000 for the S&P 500 -- a better than 50% gain from current levels.

In his talk, Siegel claims to have found a flaw in the argument that Yale professor Robert Shiller uses as Siegel's primary opponent against his use of the P/E ratio to support his claims. Shiller argues that in order to smooth the impact of a single year's fluctuations in earnings, you should use what he calls a cyclically adjusted P/E, or CAPE ratio, to measure valuation. Rather than simply looking at earnings over the past 12 months, the CAPE ratio goes back 10 years to use a moving average of inflation-adjusted earnings. And right now, the CAPE ratio for the S&P 500 stands at about 21 -- well over what you'd typically see if you expect a bull market of the magnitude Siegel sees.

Why Siegel thinks he's right
In his talk yesterday, Siegel said that he had found a flaw in Shiller's analysis. Looking at 2008, he figured that Wall Street banks Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) , along with insurance giant AIG (NYSE: AIG  ) , lost a total of $450 billion in the crisis-ridden year. The impact of the declines in financial company profits hit the S&P 500's profits by a whopping 80%.

But when Siegel checked those figures against an independent measure of corporate profits, he found a huge discrepancy. The alternative source saw only a 25% drop -- obviously huge, but nowhere near as severe as what S&P earnings figures would suggest.

As a result, although Siegel acknowledges the value of a smoothing method for P/E calculations, he believes that the financial crisis prevents the CAPE model from working correctly.

So who's right?
This isn't the first time that Siegel and Shiller have argued about valuation, and it won't be the last. Once you start going down the road of what's cyclically appropriate, it opens a whole new can of worms. For instance, ExxonMobil (NYSE: XOM  ) and Chesapeake Energy (NYSE: CHK  ) both saw huge profit gains when energy prices spiked in 2006 to mid-2008, only to fall back substantially in 2009 when oil and gas tumbled. Some argued that near-$150 oil was driven by speculation, so does CAPE make incorrect conclusions for energy stocks as well?

Reasonable people may disagree forever. But there is a middle position that has some appeal: make a smaller but still significant adjustment to earnings to reflect the 2008 anomaly.

For instance, AIG has earned almost $9.2 billion in the past year. If you accept Siegel's argument that the company's $99 billion loss in 2008 is too extreme to reflect normal cyclical activity, it still makes sense to discount earnings somewhat if they're arguably inflated by the poor showing four years ago. The same goes for Citigroup and its $11.3 billion profit in 2011 after a $27.7 billion loss in 2008. B of A, on the other hand, did its own smoothing of earnings and moreover still hasn't seen profits recover.

The real answer
If you make a smaller adjustment, you'll end up somewhere in between Siegel and Shiller. That may lead you to conclude that stocks are in a Goldilocks just-right place. But as I see it, the real takeaway is this: rather than looking at the market as a whole in determining value, accept that a market is made up of stocks, and focus on finding the best values you can. That way, you don't have to worry about whether the entire stock market is overvalued or not.

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Fool contributor Dan Caplinger finds himself in the bullish camp on stocks. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America and Citigroup. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. 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. The Fool's disclosure policy is worth its weight in gold.


Read/Post Comments (7) | Recommend This Article (13)

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 February 03, 2012, at 10:53 AM, jerr1 wrote:

    Heres a good case for bank stocks ,cure is drop intrest rates morgages to 2 percent . Instant win for banks theyll trple their income an housing market will be on fire instantly. Question is their any one in banking bussness that wil step up to plate an kick ball like at super bowl rally

  • Report this Comment On February 03, 2012, at 3:14 PM, Hawmps wrote:

    "the real takeaway is this: rather than looking at the market as a whole in determining value, accept that a market is made up of stocks, and focus on finding the best values you can. That way, you don't have to worry about whether the entire stock market is overvalued or not."

    Well said. I get shivers when I hear the phrase "investing in the stock market". Why would you want to invest in the "stock market" anyway? I prefer to invest in individual businesses (company's stock) that has the best value as determined by me at the time I turn loose of my cash and that particular stock just happens to be traded on the open market. It's like saying, "I'm going to invest in the real estate market." ...and to borrow Dan's phrase above... {Accept that a market is made up of properties, and focus on finding the best values you can. That way, you don't have to worry about whether the entire real estate market is overvalued or not.} See, it's interchangeable.

    Good stuff Dan.

  • Report this Comment On February 03, 2012, at 4:25 PM, dctodd27 wrote:

    Average earnings are always more meaningful than current earnings. Siegel found a supposed flaw in Shiller's methodology but how does he explain the current PE ratio of 110 during early 2009 low?

  • Report this Comment On February 03, 2012, at 6:05 PM, Hawmps wrote:

    Truth-

    I guess I was referring more to the "talking heads" at large that are always says the stock market this or the real estate market that and it is so broad brushed that it is impossible to make much sense out of what is being blabbed. But, I do see your point with the players here that just short the fund of the day. Moral of the story; focus on the asset, not the market it falls under.

  • Report this Comment On February 03, 2012, at 7:50 PM, 4aapl wrote:

    Or use a 2-3 year smoothing. We're far enough along that that would pull out the losses right in the fall of 08, but still give fair info.

    Or pull out the problematic sector to see how it does. That's more problematic as you are now cherry-picking, but it could yield some good comparative info.

  • Report this Comment On February 04, 2012, at 3:44 AM, goalie37 wrote:

    I can't say whether the stock market is over or under priced. I do know that the stocks that I personally follow are slightly overpriced.

  • Report this Comment On February 05, 2012, at 8:13 AM, daveandrae wrote:

    I marked this under "read again one year from now" in my investment notes. As you read through the commentary, keep in mind you had to be a subscriber in order to reply.

    In my opinion, the commentary speaks for itself. But it if doesn't, it will quickly become painfully obvious to the reader that most people LOATHE cheap stocks!!! Which is yet another reason, against overwhelming odds, why most people fail to become wealthy in this country.

    
Edd Mcdermott wrote: 
"We bring good things to ruin" should be their new motto. Andrew Liveris (DOW Chemical) and Immelt are leaders who stated their dividend will not be cut on their watch...Both, quickly proceeded to slash dividends. Fool me once...etc, etc.Perhaps bifurcation of GE will benefit new and old investors.

    Link

    02:17 pm ET October 21, 2011
Tina Patalano wrote: 
If I bought GE every time Barron's recommended it, I'd be broke.

    Link

    01:46 pm ET October 23, 2011
Zen Cheru Veettil replied: 
Haha..GE is always "cheap" if you think that GE Capital can bring in trading profits like it used to

    Link

    02:12 pm ET October 24, 2011
David Abel replied: 
I will not soon forget the day GE, under Immelt, sold those "special shares with a 10% dividend" to Warren Buffett. Everyone that held common GE shares got an instant "haircut" that day. Sorry - GE is one dog that will never go in my portfolio anytime again.

    Link

    




    04:06 pm ET October 21, 2011
Herman Unanski wrote: 
Get rid of Jeff Immelt, and I will think about buying some! How does he survive with his track record of failure? Any other American company would have fired him long ago!

    Link

    06:30 pm ET October 21, 2011
Myron Harvist wrote: 
I think the 3 people above hit it right on the head. It's a company like Microsoft - should be doing better, but ain't.

    Link

    08:54 pm ET October 21, 2011
Kirk Cornwell wrote: 
We are talking about a company with well over ten billion shares outstanding. The "strong capital position " is a feature of an almost incomprehensibly complex balance sheet. A. prolonged "15%" growth rate is virtually impossible here. Buy on the dip? Maybe. Sell on a pop. sounds wise too.

    Link

    02:50 pm ET October 22, 2011
Dana Mauch wrote: 
Stock action would benefit greatly with a 1-2 reverse stock split. 10 billion plus shares outstanding is a little much.

    Link

    02:08 pm ET October 24, 2011
David Abel wrote: 
This recommendation is almost too funny. The management of GE under Immelt has been one crisis after another. And as noted above, their balance sheet is almost incomprehensible. Then there is the millstone of GE Capital - that you can always count on for some sort of minor financial disaster every year. Oh - and last but not least - about four years ago GE was a compnay that traded in the mid-$30s - about double what it sells for now.

    Closing price – 16.31

    Dividend yield - 4.17%

    Price to book - 1.39

    Trailing p/e – 13.4

    Five year p/e average – 9.95

    Ten year p/e average -10.52

    Forward p/e – 10.59

    Market cap - 172.9 billion

    Revenue Backlog – 200 billion

    Shares outstanding 10.6 billion

    Total return as of 2-5-2012

    18.58%

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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