Bear Rebuttal: The Market Is Pricier Than You Think

I have been warning for months that stocks are, in aggregate, overvalued. Last week, my colleague Morgan Housel took the opposite position, arguing that the market may be cheaper than you think. I've examined Morgan's arguments, and I remain of the belief that stocks are expensive. Here is my rejoinder:

The most reliable earnings multiple out there
One of the central pieces of evidence for stocks' overvaluation is the cyclically adjusted P/E ratio (CAPE). Pioneered by Robert Shiller of Yale, the CAPE is based on a moving average of inflation-adjusted earnings over the previous 10 years. Currently, the CAPE for the S&P 500 is 19.9, which is 21% higher than the long-term historical average of 16.4.

Expect a small positive return
Professor Shiller, who has compiled stock market data going back to 1871, found that when the CAPE hits 20, stocks lost 2% annually, on average, after inflation. Add dividends in, and investors managed to eke out a small positive return.

Trailing P/E multiples are flawed
In his article, Morgan suggested that stock market bears are misguided in looking at P/E multiples based on trailing earnings. Naturally, as we exit a deep recession, trailing earnings are depressed, producing inflated multiples that make the market look artificially expensive. I entirely agree. However, he then tries to extend the argument to the CAPE:

You can say something similar about the CAPE (Cyclically Adjusted P/E) ratio popularized by Yale economist Robert Shiller... its relevancy has been diminished by the financial sector's 2008-2009 meltdown. The problem with using CAPE right now is the assumption that the past two years were part a normal business cycle when in fact they were more of a nuclear firestorm.

These weren't once-in-a-business-cycle losses. These were the kind of losses you might see once or twice in a lifetime. As Wharton professor Jeremy Siegel said of CAPE, "AIG's $80 billion write-off is going to pollute those figures for 10 years.

The CAPE: It does what it says on the box
A plausible argument; however, the numbers simply don't support it. Looking at Robert Shiller's data, the 10-year average real earnings figure one uses to calculate the CAPE for the S&P 500 as of May 2010 is $54.86. Now, let's go back a bit to December 2006 -- before the credit crisis began and, thus, before AIG (NYSE: AIG) or any of the banks experienced significant mortgage-related losses. What was the equivalent average earnings figure then? $55.21 -- less than 1% higher than the current figure. In other words, these "once or twice in a lifetime" losses have had virtually no impact on the average earnings used to calculate the CAPE.

Meanwhile, trailing-12-month earnings to the fourth quarter 2006 for the S&P 500 earnings were $78.57, over 30% higher than trailing 12 months earnings through the first quarter of this year ($60.93).

It should be clear that average earnings used to derive the CAPE are much more stable than trailing-12-month earnings -- that's the whole point of the CAPE. I agree with Morgan's critique of P/E multiples based on trailing earnings, but the same can't be said of the CAPE, which was conceived in order to avoid this very shortcoming.

Overvalued index, undervalued stocks
So the bad news is that stocks are indeed overvalued in aggregate, but all is not lost for stockpickers. Some individual stocks belonging to outstanding businesses look undervalued -- even on the basis of the CAPE -- as the following table proves:

Source: Author's calculations and Capital IQ, a division of Standard & Poor's.

Not that one shouldn't expect these stocks to avoid the downdraft in a market correction. However, owning shares in high-quality businesses that are trading at or below fair value offers investors protection -- unlike owning index funds when the index is overvalued.

Two types of investors, two suggestions
In this context, investors in individual stocks should assure themselves that each of their holdings is no worse than fairly valued. Meanwhile, index investors (through the SPDR S&P 500 ETF (NYSE: SPY), for example) should be underweight U.S. stocks right now -- the time to be significantly overweight a broad index is once it has declined well below fair value, not while that occurrence is merely a tangible threat.

Between high valuations and sluggish growth, investors can expect disappointing returns from U.S. stocks over the next several years. The good news is that there are alternatives for your money. Tim Hanson explains how to make more in 2010.