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A Unique Way to Value the Market

By Morgan Housel - Apr 17, 2013 at 6:03PM

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Liz Ann Sonders on investing.

One of the troubles with market punditry is that people can pick different metrics to make whatever case they're trying to make. Some cite variations of the P/E ratio to say the S&P 500 is overvalued. Others use different versions to say it's undervalued.

Truth is probably found by looking somewhere in the middle. Last week, Charles Schwab chief investment strategist Liz Ann Sonders shared a unique way she likes to value market that does just that. Here's what she had to say (transcript follows):

Sonders: I do like to look at forward P/E and make an assumption that estimates, or at least make a call that estimates are not aggressive on the high side or the low side, so if you have some confidence that the stream of estimates over the next 12 months is not out there, then I think it's valid, given that the market is a leading indicator to look forward and not drive the car purely with the rearview mirror. Even on a trailing-12-month basis, the market is still pretty cheap.

But if you want to take a Shiller-type look where you do look back and you look at long term, the one that I favor most was formulated initially by Steve Leuthold, and it's five-year normalized earnings. So it's closer to the six-year business cycle. It's four and a half years of historic earnings, two quarters of forward earnings, so you get that blend of look back and look forward. What I like what he did was he takes the midpoint between reported earnings, which has everything including the kitchen sink in it, and operating earnings, which takes out all the one-time charges. So taking the midpoint gets you a little bit of both. You get a little bit of both in terms of back and forward; you get a little bit of both in terms of the construction of earnings.

Then I think you need to do an inflation adjustment as well. On that basis, on an inflation-adjusted level, we're at about in-line valuation. So again, you can support your case regardless of where you are on the bullish-to-bear spectrum, depending on which valuation tool you decide to choose.

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