This Is Why You Should Still Be Worried

Is the market overvalued or undervalued?

Are you bored with that question yet? I know, it can seem like a tired, worn-out question. But while it may make some folks roll their eyes in exasperation, this is a very important issue and has big implications for the returns you can expect from your portfolio.

Recently, one of the big debates has been over the use of price-to-earnings ratios based on one-year earnings -- either forward- or backward-looking -- versus using average earnings over the past decade. The group using the former metric will tell you that stocks are cheap; over the long term, the average one-year P/E has been just under 16 and the current one-year trailing P/E is 14.4.

The other group will tell you exactly the opposite, that is, that stocks are pricey right now. Over the long term, the average P/E based on average 10-year earnings -- also known as the "cyclically adjusted P/E," or just CAPE -- has been 16.4 and the current average-earnings P/E is 20.8.

Who's right?

Some historical perspective
History doesn't repeat, but it rhymes, right? To me, this means we should be able to get some perspective by looking back to find instances of these two valuation measures diverging.

Looking back to the turn of the century -- the 20th century, that is -- I was able to find a number of other times when the one-year P/E made stocks look much more attractive than the CAPE. The most recent also happened to be the most favorable for investors who are currently bullish. This happened in early 1995 and was followed by five years of outstanding returns.

However, the rest of the data isn't nearly as encouraging. Pretty much every other instance of this valuation-multiple divergence was followed by five years of mediocre returns (4% to 7% range) or even losses. Interestingly, my fellow Fool Alex Dumortier predicted yesterday that returns from U.S. stocks over the next 10 years won't exceed 7%.

If you flip the divergence on its head -- that is, look for times when the CAPE suggested that stocks were undervalued while the one-year P/E suggested that they were overvalued -- you would have done better. But historically the best times to invest were (drumroll, please!) when both the CAPE and the one-year P/E suggested that stocks were undervalued. No big surprise there.

Buy, sell, or fold?
The conclusion here isn't that you'll go broke by buying U.S. stock indexes. My view ends up similar to what Alex determined -- that overall U.S. equity returns will be pretty mediocre in the years ahead. If you've determined you don't need a return of more than 4% to 7%, then this shouldn't be much of a problem for you. However, if your retirement depends on a 12% annual return, there's a good chance you're going to be disappointed if you focus your investing on U.S. index funds.

But we're Fools. We want returns that exceed the overall market, and, for many of us, a 5% annual return isn't attractive.

One option in the search for better-than-average returns is to look for stocks that have lower-than-average valuations. Above, I noted that the best returns tended to follow periods when both the 10-year average P/E and the one-year P/E looked cheap. That may not be the situation the overall market is in right now, but there are definitely some individual companies we can find that fit that profile.

Earlier this month, I introduced five stocks that are very cheap on the basis of 10-year average earnings. Below are five more that fit the mold of looking cheap on both a one-year and 10-year P/E basis.

Source: Capital IQ, a Standard & Poor's company.

Of course, your work isn't done here. While there may be some more attractive valuations available when looking at individual stocks, more research is also required. An investor getting interested in Seagate, for instance, would want to dig into the data-storage industry and get comfortable with the shifting landscape there and how it impacts a major supplier of hard disk drives. Likewise, before investing in defense contractor L-3, you'd want to make sure you have a sense for how the government's budgetary issues may impact the programs that put dollars in L-3's pocket.

Generally, though, looking at valuations on both a current, one-year basis as well as a longer-term basis gives us a good starting point for finding stocks that may be able to top the market's (mediocre) returns.

Want to start keeping an eye on the cheap stocks above? Just click on the " " sign next to any of the tickers to add it to your watchlist. Don't have a watchlist yet? Click here to start one for free.