With the S&P 500 off more than 50% from its 2007 high, investors naturally want to know whether we are in for further declines. Unfortunately, we don't know the answer to that question, but, for patient investors, there may some cause for optimism. When I contacted Andrew Smithers, a financial economist who advises institutional investors, he indicated that U.S. stocks were near fair value or perhaps even undervalued.

Why listen to Smithers? There are any number of strategists/economists/experts who have an opinion on the stock market. But Smithers' analysis is based on sound fundamental principles (I recommend his excellent Valuing Wall Street), and he has a verifiable track record of prescient calls.

An early prophet
The very last sentence in Valuing Wall Street, published in March 2000, certainly hits home:

"We therefore doubt whether it will be possible to act promptly and strongly enough to stop a major recession developing in the USA in the new millennium."

We are now in the middle of just such a recession, and the only reason it was pushed out to 2008 was the Fed's feats of policy contortionism.

"The S&P 500 seems to be fairly valued or even a little under valued"
That was then, this is now; I was eager to get Smithers' views on the market's current valuation. His answer:

"On the latest available data the S&P 500 seems to be fairly valued, or even a little under valued, using either [Tobin's] q or the cyclically adjusted PE. For example the market is selling at 12.7 times the average of the past 10 years earnings per share (at current prices), which is nearly 20% below its long term average."

At the moment, half of the stocks in the S&P 500 are trading at less than 15 times their average earnings from continuing operations per diluted share (this does not include the 40 stocks with negative average earnings). They include:


10-year Average EPS (from continuing operations)

Adjusted P/E*

Dow Chemical (NYSE:DOW)



Alcoa (NYSE:AA)



General Electric (NYSE:GE)



Chesapeake Energy (NYSE:CHK)



Merck (NYSE:MRK)



Boeing (NYSE:BA)



Pfizer (NYSE:PFE)



Source: Capital IQ, author's calculations; *based on closing prices on March 9, 2009.

Fair warning: Asserting that stocks are fairly undervalued doesn't imply that stocks can't go lower. According to data from Professor Robert Shiller, who has championed the use of 10-year average earnings to derive a meaningful P/E ratio, the market's ratio fell below 10 during the three longest recessions of the past century (The Great Depression in 1929-33, the oil shock in 1973-5, and 1981-2).

The most likely (real) return is the long-term real return: 6.02%
However, if stocks are fairly valued, investors can reasonably expect to earn something close to the historical average going forward. Smithers confirmed this when I asked him for his seven-year forecast:

"I don't think it's possible to make more than vague forecasts about the level of the stock market in 7 years time. All I can say is that the most likely level will be fair value and that, if this is the case, the return will be the same as the long-term real return. This since the end of 1899 has been 6.02%."

Don't take the advice of a banker!
How did we reach this point? Smithers doesn't mince words: "The Fed caused the current crisis by ignoring asset prices. Stephen Wright and I pointed this out in 2002 in Stock Markets & Central Bankers -- The economic consequences of Alan Greenspan." However, he's willing to praise it: "The Fed has responded quite well to [the crisis], by cutting interest rates quickly and being willing to go further with quantitative easing."

What about the Treasury? "The [Bush Administration] Treasury, however, has been inept," which comes as no surprise: "The Secretary of the Treasury [Hank Paulson] was a banker. History shows that modern bankers don't understand the problems and, as now, have conflicts of interest; they are clearly unsuitable people from whom governments should take advice about banking."

As far as I can tell, Timothy Geithner has never set foot in a bank as an employee or partner; at least he is one up on Paulson in facing this crisis.

We don't understand all the problems yet
I was curious to look further down the road: Which economic/financial trends are misunderstood or underfollowed? Smithers' answer highlights how fiendishly challenging this crisis really is:

"Nearly everything, even when it's fairly obvious, is often under-followed or misunderstood by many and some things are decidedly uncertain to everyone," he says. Still, even in the fog, there are some certainties: "Among the fairly obvious [problems], which are well understood by some, are that banks need more capital, and that personal consumption in the US and UK will fall as a % of GDP over several years."

"Corporate balance sheets are in bad shape"
Another trend is emerging that equity investors need to be aware of: "Corporate balance sheets are in bad shape. This has been disguised in the past by "mark to market accounting", but is likely to be revealed in the years ahead," Smithers says.

For stock pickers, this puts a premium on balance-sheet analysis of the sort practiced by value investor Marty Whitman. Those who aren't comfortable getting their hands dirty that way should focus on companies with pristine balance sheets and excellent disclosure or seek broad exposure to stocks through low-cost index funds.

The bottom line: 'Acceptable' is no putdown
Speaking of broad exposure, if Smithers is correct -- and I suspect he is -- equities should provide acceptable (though unspectacular) returns over the next 10 years or so. While "acceptable" returns may not get the salivary glands going, the current prospects for equities are more appetizing than some of the alternatives (cash, Treasury bonds) that are certain to leave investors malnourished.

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