Are You Paying Too Much for Your Stocks?

Last week, I took a look at stock market valuations as measured by Professor Robert Shiller's CAPE -- that is, the cyclically adjusted price-to-earnings ratio. Recapping in short, that measure seems to show that over the past decade-plus, valuations have been elevated well above their historical averages and seem due (overdue?) to for a period of lower valuations.

Frankly, I don't really like the idea that all stocks are overpriced right now, and a handful of my readers weren't keen on that idea either. I'm certainly not content with giving such an important issue a quick treatment, so let's dig in a bit further.

Brutal recessions
One commenter on my previous article, Sambar2pi, noted that the CAPE could be high right now because we've had multiple recessions over the past 10 years:

A high CAPE could mean current prices are historically high... but it could also mean earnings have been historically low, which wouldn't be surprising considering two (major) recessions have occurred in the past 10 years.

That's certainly true, but there are two reasons why I wouldn't be so quick to jump on this as a reason to dismiss the CAPE's cautionary result. The first reason is that the whole idea behind the CAPE is that it captures earnings over cycles so that it averages out the high earnings of the good times with the lower earnings of bad times. And while the more recent recession was unusually bad, the recession following the dotcom bust was actually a bit shallow by historical standards.

The second reason I'm wary about that logic is that if we hypothetically assume that instead of having a recession at the beginning of the millennium we had the peak earnings from 2000 extend through to 2004 and that the same thing happened with the more recent recession -- this time with 2007 peak earnings -- the CAPE falls drastically, but is still above the long-term average. That's not terribly comforting.

These stocks are deals!
Fool member daveandrae also weighed in on the discussion, stating:

Anytime you can purchase a small piece of a quality business like [Merck (NYSE: MRK)] at less than 11 times its five year average earnings when ten year bond yields are less than 4%, equity investing makes sense.

In fact, there are a lot of stocks that look cheap right now, and that's part of the reason why I'm loath to say that all stocks are overpriced. But the problem is that part of the reason valuations look so tempting right now is because they've been so ridiculously overpriced over the past 10 years.

Coca-Cola at less than 20 times trailing earnings may seem reasonable, but that's largely because we were paying more than 24 times for it in 2007 and a whopping 71 times in 2000. And Cisco's (Nasdaq: CSCO) stock at 16 times earnings is blowing a lot of peoples' minds, but, again, that's partly because investors were valuing it at 26 times earnings in 2007 and 173 (!) times in 2000.

Other stocks look almost unquestionably cheap on an absolute basis. AT&T, for example, is trading at mere 8.7 times earnings while ConocoPhillips' stock fetches 9.5 times earnings. But if we rewind to 1982, when the CAPE was well below its long-term average at 7.4, both ExxonMobil and United Technologies' stocks could be had for 4.8 times earnings, while Coca-Cola was valued at less than nine times earnings. And those were the norms, not the exceptions, at the time.

Of course the interest rate environment was very different in 1982 than it is today, but I'd no sooner bet on interest rates staying as low as they are today than I'd quit my job to enter the NFL draft.

Stick with the cheap stocks
Even taking all that into consideration, I wouldn't call myself a bear right now. There are a number of factors that could continue to fuel investor bullishness -- regardless of valuations.

More importantly, the stocks that make up the market don't all carry the same valuations. So even though the overall market's valuation may not be especially appealing, we can still find stocks that have more attractive valuations. In a continued bull market, these lower-valued stocks would have upside potential as their valuation multiples caught up to the rest of the market, while in a falling market their already-low valuations would provide investors with some downside protection.

In keeping with the CAPE, I looked at the valuations of S&P 500 stocks in terms of average 10-year earnings as well as the more-oft-used one-year price-to-earnings ratio. Here are a few of the cheapest stocks in the index.

Source: Capital IQ, a Standard & Poor's company, and author's calculations. P/E=Price to earnings ratio.

A low valuation alone doesn't guarantee that a stock is a good investment. But these five could be a good starting point for finding stocks that are still attractive buys in today's market.

Have some of your own thoughts on what stocks are cheapest in this market? Head down to the comments section and sound off. Otherwise, you can check out five more stocks that my fellow Fool Morgan Housel thinks are worthwhile buys today.