Fear. There simply isn't enough of it to go around these days. The VIX -- Wall Street's "fear gauge" -- closed at 22.32 yesterday. It reflects investors' expectations for future stock market volatility, and prior to the second half of November, we hadn't seen such low values since early September 2008 -- the pre-Lehman bankruptcy era.

Why should investors care about this seemingly arcane number? As Warren Buffett wrote in an October 2008 New York Times op-ed column: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."

Applying Buffett's rule
In that opinion piece, Buffett exhorted investors to buy on the rationale that "fear is now widespread."

What a difference 14 months makes! With much of the fear out of the market, investors' temperament now appears tipped toward greed. The VIX isn't the only indicator of this -- any decent market observer should be tripping over the signs -- and it's by no means a U.S.-centric phenomenon, either. Buffett's rule now suggests that, rather than buying heavily, prudent investors should favor caution.

But not all parts of the market point to investor complacency. According to data compiled by U.K. bank Barclays and Bloomberg, the difference in price between one-month and one-year options on the S&P 500 is higher than at any time since 1999, highlighting investor concern that analyst estimates of record earnings by 2011 are overoptimistic.

The earnings risk hanging over the U.S. market
Analysts are now calling for a 20% increase in S&P 500 earnings in each of the next two years -- the fastest rate since 1994.

The scope of this enthusiasm becomes apparent at the company level. Just look at the following companies, each of which has seen earnings estimate skyrocket over the past 12 months.


12-Month % Change in Consensus Fiscal Year 2010 EPS Estimate

Forward P/E (Fiscal Year 2010 Estimated Earnings)




Corning (NYSE:GLW)



Freeport-McMoRan (NYSE:FCX)






Gilead Sciences (NYSE:GILD)



Amazon.com (NYSE:AMZN)






Source: Capital IQ, a division of Standard & Poor's.

This certainly appears inconsistent with an economy in which consumer credit remains tight and unemployment remains elevated. Speaking at the Economic Club in Washington on Dec. 7, Fed chief Ben Bernanke -- who's hardly an inveterate bear -- said "we still have some way to go before we can be assured that the recovery will be self-sustaining."

In fact, although the forward P/E of the S&P 500 looks like a quite reasonable 16.3, a more reliable multiple tells a different story altogether. According to data compiled by Professor Robert Shiller of Yale, the S&P 500 is trading at a cyclically adjusted price-to-earnings (CAPE) multiple of 20.0, more than 20% above its long-term historical average (the CAPE compares price to the average inflation-adjusted earnings over the prior 10-year period).

In other words, the U.S. market is overvalued.

Two strategies in an overbought market
Given that the market is overvalued, investors are left with two alternatives:

  • If you are mainly an index investor (i.e., your exposure to U.S. stocks is through index mutual funds or ETFs), you should be underweight the broad U.S. market.
  • If you prefer to invest in individual stocks, it is acceptable for your portfolio to carry a normal weighting in equities if the names in your portfolio are no more than fairly valued (it's preferable that they carry a margin of safety).

In short, valuation is key, because it's what drives returns over the long term.

Stockpickers: Valuations are vital
If you're not following one of these two strategies -- both of which are driven by valuation -- you may currently be at risk of suffering unacceptable (and unnecessary) capital losses.

The team at Motley Fool Inside Value is always focused on valuation. They can show you how to build and manage a portfolio around 8 "Core Stocks" -- rock-solid businesses with attractive growth prospects that have the potential to underpin healthy, low-risk returns in your portfolio over the next decade. If you'd like to find out more about these Core Stocks, as well as Inside Value's six "Best Buys Now," sign up for a 30-day free trial today by clicking here.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor recommendation. Intel is an Inside Value recommendation. Motley Fool Options has recommended calls on Intel. Motley Fool has a disclosure policy.