Stocks Are More Expensive Than Ever

To the casual eye, stocks appear extremely cheap, especially compared to where they were back in late 2007. When you look more closely at valuations, however, you may get the exact opposite impression: that stocks are actually quite expensive.

Here's a quick look at the facts:

• After peaking above 1,575 in October 2007, the S&P 500 stands at just over 800 as of Wednesday.
• Corporate earnings, however, have plummeted. During 2008, S&P 500 companies earned a total of just $15.09 per share.
• That puts the year-end trailing price-to-earnings ratio, based on the S&P's close around 900, just a bit under 60. That's the highest quarterly closing P/E on record.

So who's right: bulls who say you should be buying stocks hand over fist like a Black Friday shopper bursting through the doors at 5 a.m. -- or bears arguing in favor of the duck-and-cover method of investing until valuations go even lower?

Valuing stocks in a recession
This month's brand-new issue of the Motley Fool's Rule Your Retirement newsletter -- which hits digital newsstands this afternoon at 4 p.m. ET -- examines in more detail the dilemma of using earnings-based valuations during a recession. During ordinary times, while there may be some variation in the earnings of individual companies, total earnings for a large group of stocks moves fairly smoothly. That, in turn, keeps P/E ratios from jumping too wildly.

In a recession, however, those figures become much bumpier. Items like goodwill impairment, writedowns of bad assets by financial companies, and restructuring charges tend to come in clumps during bad times, depressing earnings on a (hopefully) one-time basis and therefore pushing P/E ratios upward even in a falling market.

To give you a better sense of the impact that just a few companies have had on the S&P's earnings, take a look at these figures:

Sources: Yahoo! Finance, IndexArb.com.

According to Capital IQ, fully 95 S&P stocks have had negative earnings over the past 12 months. And during the fourth quarter of 2008, overall S&P quarterly earnings were negative for the first time ever.

A tale of two markets
One problem with big-picture market valuation analysis is that you can miss finer trends within the overall market. The companies that posted losses in 2008 -- largely in struggling sectors like financials, automakers, and homebuilders -- obscure many attractive valuations among more promising companies.

For example, Novartis (NYSE:NVS) has a trailing P/E of just 10.7 and a forward estimated P/E of 9.9. General Dynamics (NYSE:GD), meanwhile, sports trailing and forward P/Es of about 7. Analysts still expect both of them to grow -- albeit slowly -- during this year and next. But if you focus only on the general market, you might miss these and other stocks worth a closer look.

In Rule Your Retirement's analysis of this question, Fool expert Robert Brokamp and his team look at valuation methods beyond simple P/E ratios. With them, you can smooth out earnings that are temporarily depressed during a recession and make some stronger conclusions about the market's prospects. Using those tools, the newsletter team makes a well-reasoned call on where stocks are likely to go next, pointing both to the prospective worst-case scenario as well as what could happen when earnings jump back to reasonable levels after the recession ends.

Learn more
To see more of this analysis and learn what recommendations the Rule Your Retirement team is making right now, take a look at this month's brand new issue. Although access is limited to subscribers, you can take advantage of our 30-day free trial to get a sneak peek at this article as well as other helpful discussions of various market topics.

For more on investing in a tough market:

• Three investment myths you shouldn't buy into.
• Use options for a successful retirement.
• Is living forever your retirement plan B?