Pop quiz, hotshot: The S&P is up more than 70% from its closing low last March. If the market continues to go up, you want to ride along with it. But if it reverses course, you want to protect your nest egg. So what do you do?
The answer seems obvious, right? U.S. unemployment is still close to double digits, troubled financials like AIG
But wait just a second there. Earnings reports from the likes of FedEx
Don't mind the 70%
Stock market commentators tend to be a rather fearful bunch. When times get bad and the market is sinking, many of them seem to suffer from taphephobia -- a fear of getting buried alive -- and they want to run for the hills as quickly as possible. On the flip side, when the market is shooting up, acrophobia -- the fear of heights -- seems to come into play and, well, they're off running for the hills again.
But if you ask me – or, really, any fundamentals-oriented investor -- our concern shouldn't rest with how much the market has gone up or down, but rather whether its valuation is attractive or unattractive. If a hot market with sky-high valuations rises 70%, that acrophobia is probably warranted. On the other hand, if a sorely undervalued market tacks on that same 70%, there could still be good reason to buy.
Do mind the valuation
There are many ways to track the market's valuation, but I'm a big fan of the work that Robert Shiller of Yale has done. He maintains a spreadsheet that tracks the S&P's price and earnings going all the way back to 1871 and tracks the market's valuation by comparing price with the average earnings over the past 10 years.
The long-term average P/E ratio is around 16.4. The current readout is getting close to 21, which is up from 13.3 in last March and down from 27 prior to the market's crash. So today's valuation isn't nearly as attractive as March's, but it's more attractive than what was available to us before the recession.
What's concerning, though, is that earnings estimates for the S&P index from Standard & Poor's suggest that earnings will remain below their prerecession levels. This means that even if the market doesn't move up much more, its valuation will stay high as earnings plod along.
Switching to a single-year P/E doesn't help a whole heck of a lot. Currently, that measure is also above the historical average, and it's expected to still be close to that average at the end of 2010, even if the S&P's price doesn't budge from today's level.
So what do you do?
Back in March of last year, when the market's valuation was undeniably low, it was difficult to go wrong with buying an index fund and calling it a day. Sure, you could have done better buying certain individual stocks such as Sirius XM Radio
If you're a long-term retirement investor and you want to keep it simple, you still may be OK grabbing those index funds today. For investors who like to put on a hard hat and go prospecting for the best stock opportunities, though, now is a good time to start eschewing the index funds in favor of individual stocks that are still undervalued.
And while I think the stocks of those blue-chip candidates could perform quite well, there may be even more opportunity for investors willing to consider small-cap stocks. The world of small caps is a largely uncharted sea of stocks that most institutional types avoid because they're too small to make an impact on huge mutual fund portfolios. For individual investors, though, they can be a great way to find hidden value -- particularly at the early stages of an economic recovery.
If you're looking for stock ideas, the advisors at Motley Fool Hidden Gems are a great resource for new or veteran small-cap hunters. You can see their six Buy First stocks and read the research on all of their recommendations free for 30 days. Click here to get started.
Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned in this article. Best Buy is a Motley Fool Inside Value recommendation. Best Buy and FedEx are Motley Fool Stock Advisor selections. The Fool owns shares of Best Buy. The Fool's disclosure policy enjoyed Speed in spite of Keanu Reeves.