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Stocks Are Fairly Valued -- at Long Last!

Alex Dumortier, CFA
March 11, 2009

With the S&P 500 off more than 50% from its 2007 high, investors naturally want to know whether we are in for further declines. Unfortunately, we don't know the answer to that question, but, for patient investors, there may some cause for optimism. When I contacted Andrew Smithers, a financial economist who advises institutional investors, he indicated that U.S. stocks were near fair value or perhaps even undervalued.

Why listen to Smithers? There are any number of strategists/economists/experts who have an opinion on the stock market. But Smithers' analysis is based on sound fundamental principles (I recommend his excellent Valuing Wall Street), and he has a verifiable track record of prescient calls.

An early prophet
The very last sentence in Valuing Wall Street, published in March 2000, certainly hits home:

"We therefore doubt whether it will be possible to act promptly and strongly enough to stop a major recession developing in the USA in the new millennium."

We are now in the middle of just such a recession, and the only reason it was pushed out to 2008 was the Fed's feats of policy contortionism.

"The S&P 500 seems to be fairly valued or even a little under valued"
That was then, this is now; I was eager to get Smithers' views on the market's current valuation. His answer:

"On the latest available data the S&P 500 seems to be fairly valued, or even a little under valued, using either [Tobin's] q or the cyclically adjusted PE. For example the market is selling at 12.7 times the average of the past 10 years earnings per share (at current prices), which is nearly 20% below its long term average."

At the moment, half of the stocks in the S&P 500 are trading at less than 15 times their average earnings from continuing operations per diluted share (this does not include the 40 stocks with negative average earnings). They include:


10-year Average EPS (from continuing operations)

Adjusted P/E*

Dow Chemical (NYSE: DOW  )



Alcoa (NYSE: AA  )



General Electric (NYSE: GE  )



Chesapeake Energy (NYSE: CHK  )



Merck (NYSE: MRK  )



Boeing (NYSE: BA  )



Pfizer (NYSE: PFE  )



Source: Capital IQ, author's calculations; *based on closing prices on March 9, 2009.

Fair warning: Asserting that stocks are fairly undervalued doesn't imply that stocks can't go lower. According to data from Professor Robert Shiller, who has championed the use of 10-year average earnings to derive a meaningful P/E ratio, the market's ratio fell below 10 during the three longest recessions of the past century (The Great Depression in 1929-33, the oil shock in 1973-5, and 1981-2).

The most likely (real) return is the long-term real return: 6.02%
However, if stocks are fairly valued, investors can reasonably expect to earn something close to the historical average going forward. Smithers confirmed this when I asked him for his seven-year forecast:

"I don't think it's possible to make more than vague forecasts about the level of the stock market in 7 years time. All I can say is that the most likely level will be fair value and that, if this is the case, the return will be the same as the long-term real return. This since the end of 1899 has been 6.02%."

Don't take the advice of a banker!
How did we reach this point? Smithers doesn't mince words: "The Fed caused the current crisis by ignoring asset prices. Stephen Wright and I pointed this out in 2002 in Stock Markets & Central Bankers -- The economic consequences of Alan Greenspan." However, he's willing to praise it: "The Fed has responded qui