Yesterday, my fellow Fool Alex Dumortier presented a relatively bearish case for the market, suggesting that recent slumps are signs that the market is overextended and ready to make a potentially significant dip.

In recent months, I've been thinking along the same lines. In his article, Alex mentions the valuation work by Yale economist Robert Shiller, who has maintained running calculations of 10-year average price-to-earnings ratios (or "cyclically adjusted" P/Es, as he calls them) for the S&P composite index going back to 1881. The implications of this key piece of valuation data have been troubling me lately, because the current 10-year average P/E ratio is 19.7 -- notably above the long-term average of 16.4.

And you can't argue with data can you?

Who said I want to argue?
The thing to remember about valuations is that they're not a binary signal telling you whether you should be jumping in or out of the market. Rather, they're a signpost to the kind of returns you can expect from whatever you're investing in. As a simple rule, the higher the valuation you pay for any given investment, the lower your returns are going to be.

When we look at Shiller's data, it should be noted that the average cyclically adjusted P/E over the past 30 years has been 21.2, suggesting that a reading of 19.7 might not mean an imminent fall in the market. In fact, it may mean the market will continue to rise.

But whether the market falls back to a cyclically adjusted P/E of 16.4 or rises to 21.2, the simple idea above holds true: The higher the valuation you pay, the lower your returns are likely to be.

Buy, sell, or fold?
With that in mind, investors -- particularly those with a long-term focus -- shouldn't care whether the market is going to rise or fall tomorrow, next month, or next year. The key is buying stocks at valuations that imply attractive results, and making sure those stocks are backed by companies that will live up to your expectations.

But enough beating around the bush. Are there stocks out there right now that could still produce attractive returns? In his article, Alex highlighted GMO Chairman Jeremy Grantham's most recent investor letter and his dour view of the U.S. equity markets.

However, if we go beyond the broad market picture, it's notable that Grantham points out that many risky stocks have been the prime beneficiaries of the market's advances and are a particularly overvalued group. I can only assume he's referring to stocks like Las Vegas Sands (NYSE:LVS) and Fifth Third Bancorp (NASDAQ:FITB), which have gone from being considered close to dead to putting up ridiculous returns.

Meanwhile, he singles out "U.S. high quality" equities as a group that's relatively underpriced and could handily outperform the rest of the market. In his seven-year return forecasts, he suggests that this high-quality group could deliver 6.8% per year versus 1.3% for all U.S. large-cap equities.

In his letter, Grantham doesn't exactly spell out what constitutes a "U.S. high quality" equity, or offer up specific stock picks, but we can probably safely assume that his fund holds goodly chunks of these "high quality" potential outperformers. Here's a peek at some of GMO's top 10 stock holdings:


Dollar Amount

Percentage of
GMO Portfolio

Price-to-Earnings Ratio

Johnson & Johnson (NYSE:JNJ)

$1.6 billion




$1.5 billion



Wal-Mart Stores

$1.4 billion




$1.3 billion



Pfizer (NYSE:PFE)

$1.3 billion



Procter & Gamble (NYSE:PG)

$1.0 billion



PepsiCo (NYSE:PEP)

$850 million



Sources: Capital IQ (a Standard & Poor's company) and Yahoo! Finance.

Boring? You betcha. But this is about long-term wealth-building. If you want adventure and excitement, I hear bungee jumping is quite a thrill.

My fellow Fool Jordan DiPietro thinks that a particular group of stocks could burn you in 2010, while another could give you an edge.

Microsoft, Pfizer, and Wal-Mart are Motley Fool Inside Value selections. Johnson & Johnson, PepsiCo, and Procter & Gamble are Income Investor selections. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Oracle and Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Johnson & Johnson, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...