Are Stocks Expensive or Undervalued?

It's the $100,000 question that everyone is dying to know the answer to -- where is the stock market headed next? Is the worst behind us, with the market eager to get back to the business of making us money, or is this just a brief respite before an even worse and longer-lasting decline? Investors are split on whether the stock market is undervalued or overvalued, and so are some of the industry's brightest professional minds.

Going head-to-head
Celebrated economists Robert Shiller and Jeremy Siegel are taking opposing positions on the market's current valuation level. In a recent Wall Street Journal article, the men presented their respective cases, Shiller arguing that stocks look expensive right now and Siegel holding the view that stocks are on track to keep producing.

Shiller cites historical price-to-earnings data that shows that not only are stocks relatively expensive, but they also have spent much of their time in the past few decades trading above their historical P/E average. This information suggests that the market's P/E ratio will fall back toward the average and pull stocks with it. If that happens, we're on track for a spell of disappointing equity returns in the near future.

On the other hand, Siegel prefers to look at projected future earnings to determine relative valuations. According to these measures, he says, the market is actually undervalued, given that profits are just beginning to rebound. He believes the market could easily see 10%-12% annual stock returns in the coming years.

Best of both worlds
So who's right? Well, I hate to be a fence-sitter here, but I think both men are correct. I do think stocks may be marginally overvalued right now, but not excessively so. However, longer-term, the stock market's prospects are still likely to be pretty darn good.

Employing the historical cyclically adjusted P/E data available from Robert Shiller's website (using average inflation-adjusted earnings over the trailing 10 years), we observe that the average P/E ratio going back to 1881 clocks in at 16.4. That's quite a bit below today's figure of 20.6 and indicative of an overvalued market. But perhaps data from the turn of the 20th century may not be quite as relevant in today's economy. If we look at more recent decades, average P/Es rise, making today's market not look quite as pricey. It's still a touch overvalued, but it hardly warrants a call for alarm.

Source: www.econ.yale.edu/~shiller/.

I'm not sure I agree with Siegel's approach of using analyst projections for future earnings. I understand the rationale behind using a forward-looking measure, but relying on analysts' notoriously optimistic assumptions is asking for trouble. In general, I do think we've seen the biggest rebound burst we're going to see in this immediate recovery period and that returns in the near future are likely to be uninspiring.

However, even if a period of subpar returns may be on tap for the immediate future, I still believe the long-term outlook for the stock market is a positive one. Consider that stocks have returned basically nothing over the past decade: Because returns were so far below the long-run average in the past 10 years, the old theory of reversion to the mean tells us that the next decade is likely to be, at the very least, more productive than the previous one. Siegel is right that U.S. companies are just now revving up their profits, and the earnings picture is likely to be much stronger one year and five years down the road. This outlook translates directly into greater economic and stock market growth for long-term investors.

Digging for bargains
If nothing else, the data suggests that the market is probably pretty fully valued right now. In such a market, stock picking becomes even more important for investors looking to squeeze out a little more return from their portfolio. If you're looking for one area of the market that has the potential to outperform as the recovery takes hold, look no further than information technology. Companies slashed tech spending viciously during the most recent recession, as they put off spending on new equipment. But firms can't delay replacing their technology forever, so tech purchases are likely to blossom once companies loosen the purse strings.

To capitalize on this trend, you'll want to look for larger tech-related companies that are selling at reasonable valuations, compared with the market and with their peers. Take, for example, the following:

Source: Yahoo! Finance.

Of course, there are other big tech names, such as Apple (Nasdaq: AAPL) and Oracle (Nasdaq: ORCL), that are also hands-on favorites to benefit from a resurgence in tech spending. But with P/E ratios around 22 for each, these companies are trading at higher premiums and may not have quite as much room for appreciation in the near future.

Ultimately, investors should remain invested in the stock market for the long term while keeping their near-term expectations in check. Stocks may not dazzle this year, but they still remain the easiest way to build wealth and meet your goals over the long run.