Following a terrific start to the month, U.S. stocks are little changed on early afternoon trading on Wednesday. The S&P 500 and the Dow Jones Industrial Average (SNPINDEX: ^GSPC) (DJINDICES:^DJI) (DJINDICES:$INDU) are down 0.07% and 0.16%, respectively, at 2:01 p.m. ET. Marc Faber, the normally bearish publisher of the Doom, Gloom & Boom Report, told CNBC this morning that the market became "extremely oversold" in February, producing the conditions for a "relatively strong rally" that could drive the S&P 500 to 2,050. However, he is not confident the market will achieve a new high, and if it were to do so, it would be with "very few stocks participating."
Think like an investor
"Oversold" is a technical term and is, therefore, part of a trader's lexicon. For an investor, the relevant question is not whether the market is overbought or oversold, but whether it is over- or undervalued.
At its intraday low of 1,810.10 on Feb. 11, the S&P 500 was valued at 23 times average real earnings per share over the past decade (this is known as the cyclically adjusted price-to-earnings ratio, or CAPE). A comparison with an average multiple of 19.6 times since March 1957 (the era of the modern S&P 500 Index) suggests were not significantly overvalued at any point this year.
As of yesterday's close, the market was valued at 25.2 cyclically adjusted earnings.
But while the market in aggregate may never have been overvalued, the sell-off did create selective opportunities for patient investors, some of which have persisted even as the indexes have climbed out of correction territory.
Take shares of Apple , for example, which dipped back below $100 today after having closed in the triple digits yesterday for the first time since Jan. 26. Reminder: The current price is equivalent to a single-digit price-to-earnings multiple (9.8, according to data from Morningstar).
Here's another way to think about this situation: Even though the cyclically adjusted P/E ratio systematically suggests an overvaluation for companies that have experienced very high earnings growth (the early year earnings drag average earnings down to a level that is likely to understate the company's current earnings power), Apple's CAPE is roughly the same as that of the S&P 500.
A 40-fold increase in earnings per share
Meanwhile, over the 10-year period to Sep. 26, 2015, Apple's earnings per share grew over 40-fold, compared to an increase of less than 40% in the S&P 500's EPS over the same period.
Consider that Apple's annual EPS would need to decline by 60% to get back to their nominal average over its past 10 fiscal years. For the S&P 500, the equivalent decline is less than one-fifth (-17%).
Two distinct conclusions
On that basis, Apple shares are almost certainly cheap relative to the broad market. In fact, the disparity is wide enough to inspire two very different observations:
- A disparity of this magnitude suggests that Apple is an obvious buy in this market.
- A disparity of this magnitude affecting a company that is at once the most valuable company in the world and (arguably) the highest-profile consumer brand is difficult to reconcile with the notion of an efficient market. Therefore, the disparity must be an illusion.
I have a healthy respect for the market, but I continue to think that No. 1 holds, not No. 2.