As the Market Hits a New High, So Does Risk

The Dow Jones Industrial Average and the S&P 500 both achieved new highs for 2009 yesterday. As my colleague Morgan Housel wrote last Friday, optimism is back! Splendid news for stock investors, indeed … or not. Would it surprise you to learn that it is much riskier to buy U.S. stocks now than it was at the beginning of March, when fear and panic were at their highs?

It comes down to valuation (as always)
The reason? Price. At yesterday's closing value of 1,028, the S&P 500 is trading at 18.4 times its cyclically-adjusted earnings (average inflation-adjusted earnings over the prior 10 years). That is a 12% premium to the multiple's long-term average going back nearly 130 years.

The cyclically-adjusted P/E ratio -- or CAPE -- was originally pioneered by investing legend Ben Graham. It is one of the only indicators that has consistently proved its worth in identifying whether the U.S. stock market is significantly over- or undervalued.

Why pay a premium now?
Under normal circumstances, a 12% premium wouldn't really be troublesome. However, when one factors in the (high) likelihood of a protracted, weak economic recovery, any premium is problematic. By contrast, on March 9th, the date on which the stock market hit its crisis low, one could have "purchased" the S&P 500 for just 11.8 times cyclically-adjusted earnings -- a 28% discount to the long-term average. (For the skeptics: One could have derived this figure at the time -- the CAPE isn't just useful in hindsight.)

The increase in the earnings multiple is even more striking for some individual stocks (these one-year forward earnings multiples must be treated with caution -- they do not necessarily imply that any of these stocks are overvalued):

Granted, the outlook then and now isn't exactly the same, but, despite being nearer the end of the recession, the world hasn't changed all that much in the last five and a half months -- certainly nowhere near enough to warrant the CAPE's current premium to its historical average. That investors should be more excited to buy stocks at current prices defies rationality.

What's an investor to do?
I've warned repeatedly in recent weeks that the market is overvalued and that we should, therefore, expect a correction. Investors with broad exposure to U.S. stocks should consider rebalancing their exposure with a keen eye to valuation. High-quality companies are one alternative, international stocks are another.

Jeremy Grantham's firm, GMO, is forecasting that "high-quality" U.S. stocks will beat large-cap stocks by more than six percentage points annually over the next seven years! Morgan Housel has identified three high-quality companies that are still cheap.