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Even as the stock market has hit multiyear highs recently, stocks still look cheap by many standards. Yet many investors are staying on the sidelines, fearing an imminent end to the three-year-old bull bounce after the market meltdown of 2008 and early 2009. That leaves one key question: Is keeping cash available a smart move or a waste of capital?
The bull argument
A recent article from Bloomberg said that the S&P 500 is almost as cheap as it ever has been compared to bond yields. When you take the S&P 500's earnings and divide it by the current level of the index, you get what's known as an earnings yield. Right now, that yield is 7.1%, and the spread over current 10-year Treasuries is more than 5 percentage points -- its lowest level since the market's bottom in March 2009.
More encouraging for stocks is the fact that companies appear to be starting to funnel more of their cash into capital investment. Having spent years bolstering their balance sheets after finding themselves cash-poor at critical moments during the financial crisis, many companies are finally loosening the purse strings. Now, capital investment is growing at its fastest pace since before the financial crisis. And assuming that the returns on that investment can exceed the 2% or so that Treasuries are earning right now, the benefits should fall through to corporate bottom lines.
Some warning signs
Of course, for every argument, there's a counterargument. One of the biggest, many believe, is that rates in the bond market are artificially low. The Federal Reserve owns more than $1.5 trillion in Treasury notes and bonds on its balance sheet, as well as more than $840 billion more in mortgage-backed securities. That demand is serving to keep rates lower, discouraging saving both among consumers and businesses. When the Fed finally acts to shrink its balance sheet, then rates should naturally rise.
Moreover, on the other hand, earnings have gotten a huge boost in recent years from improvements in productivity and profit margins. Yet with high levels of unemployment, pressure on companies to boost their payrolls could force them to reverse that trend, sacrificing productivity for job gains. That in turn could halt recent earnings growth, pushing earnings yields lower.
Great margins of safety
If you're looking to get money back into the market, cheap valuations for the overall market shouldn't persuade you just to buy an index fund. If you're diligent, you can find even better earnings yields even among blue chip stocks.
For instance, energy companies are priced as though $100 oil will be a fleeting phenomenon. Both Chevron (NYSE: CVX ) and ConocoPhillips (NYSE: COP ) carry earnings yields of 12% or better at current levels. Moreover, with Conoco planning to split off its refining division from its core exploration and production business, shares may have a catalyst to advance in the near future -- even if energy prices hit a plateau.
Technology companies are also presenting some attractive values. Corning (NYSE: GLW ) , for instance, has one of the hottest products in its Gorilla Glass, which many mobile-device makers rely on for durable screens. Yet the stock gives shareholders an earnings yield of 13% right now, pretty much discounting any prospects for future growth.
Finally, automakers look cheap. Despite the obvious challenges of a struggling Europe and a slow recovery in the U.S., both Ford (NYSE: F ) and General Motors (NYSE: GM ) have seen recent strength. In particular, with GM having gone through bankruptcy, it's arguably in the best financial condition in years -- yet investors are still treating it with the same kid gloves they did before its massive restructuring.
Stocks may look cheaper than ever by some metrics, but that doesn't mean that you can afford to buy just any stock. By looking for even better bargains, you can give yourself a margin of safety that could help prevent big losses in case the current bull run comes to an abrupt end.
If you're truly a long-term investor, then finding smart stocks has even larger benefits. To get some smart investment ideas, check out The Motley Fool's latest special report. We highlight three smart stock picks for retirement investors, and we won't charge you anything at all for it -- but it won't be around forever, so read it today while it's still available.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.