If you’re looking to start an argument about the stock market, bringing up the subject of market valuations will usually do the trick. There are as many ways to look at valuations as there are ways to interpret the indicators. So, we thought we’d grab a handful of charts and see if stocks are overvalued, undervalued, or fairly valued.

For starters, we’re going to toss out the most popular valuation metric: the Price-to-Earnings (or P/E) Ratio. The reason we’re going to ignore the granddaddy of valuation measures is simple. Since the “E” (earnings) in the formula fell off a cliff during the recession and the “P” (Price) has enjoyed a strong rebound, the P/E is sky high right now. Therefore, the current reading should be considered at outlier from a statistical standpoint. Granted, the P/E always skyrockets after a recession as earnings take a dive, but this is the worst we’ve ever seen.

To counter the problem, the bulls suggest that we should be looking at the projected earnings for 2010 and 2011, which are expected to rise considerably. In addition, with interest rates at nearly record lows, our heroes in horns argue that stocks are actually undervalued right now.

While we are card-carrying members of the glass-is-at-least-half-full club here at TSP, we do need to point out that the words “expected” and “earnings” should probably never be used in the same sentence – ever. You see, the track record of analysts’ calls on most company’s earnings is simply abysmal. For example, the margin of error for analyst estimates over the past three quarters has exceeded 55%. Therefore, the idea of taking the estimates for 500 companies and expecting the summation to be anything even remotely accurate at this point in the economic cycle is almost laughable.

In addition, companies love to play the “operating earnings” game, where they simply toss out anything on the books they don’t like in order to come up with earnings that look better. Needless to say, this “financial engineering” is akin to cooking the books and isn’t very helpful when trying to get a handle on what actual earnings are going to look like. So, while we are happy to play the expectations-versus-reality game during earnings season for individual companies, we aren’t going to waste much time basing our investment strategy on the earnings guesstimates for the S&P 500.

On the other hand, dividends ARE real. When a company pays a dividend, it bucks up cold, hard cash and sends it off to shareholders. So, when looking at valuations, we prefer to look at the P/D (Price-to-Dividend) ratio. But unfortunately, the paying of dividends fell out of favor over the past several years. As we explained in Do Dividends Matter? companies focused more on buying back stock than on paying dividends. Thus, one could argue that the P/D might be a little skewed. Be that as it may, we should probably point out that the current P/D is higher than at any time prior to 1996 and is nowhere near what would be considered “normal” – let alone the “undervalued” region.

Next up is the Price-to-Book ratio, which compares stock prices to their book values. As of the end of November, the current P/B reading for the S&P 500 is 2.4, which is up nicely from the low seen earlier in the year of 1.6. But it is important to note that (1) the average P/B over the past 84 years has been 1.88 and (2) the current reading is higher than it was before the “Crash” in 1987… higher than it was in 1965… and higher than in 1937. So, while the Price-to-Book is well off its bubble-induced high in 2000, it remains well above the historical norm.

We could also look at Price-to-Sales and Price-to-Cash Flows. However, I’ll save us all some time and simply say that the historical data looks a lot like the Price-to-Book situation. Sure, the readings are off their highs seen in the 2000-02 period, but they are still at or above historical highs.

Because earnings are so volatile, Robert Shiller came up with a rather ingenious method of looking at valuations. Professor Shiller takes earnings over a 10-year time-frame and averages them out in order to smooth out the volatility. He then adjusts for inflation in order to come to his valuation model, which he takes back into the 1880’s.

The good news here is that this Price-to-Normalized Inflation Adjusted Earnings shows that the S&P 500 is not as overvalued as it was in the late 1960’s or the 1930’s. However, at a reading of 20, it isn’t cheap either as the average since 1880 has been a hair over 16.

The analysts at Ned Davis Research went back in history and figured out how the stock market (as defined by the S&P 500) performed when Shiller’s valuation model was above and below the normal zone. Since 1880, when the Shiller model has been above 16, the S&P 500 actually has lost ground at a rate of -0.4% per year.

I know what you’re thinking. With interest rates so low, shouldn’t we be focused on the so-called Fed Model, which compares stock yields to interest rates? While this is indeed logical, there are a couple of problems with this concept.

The first problem is that interest rates are artificially low in response to the greatest financial crisis of our generation. Thus, comparing rates that were forced down to stave off Financial Armageddon probably doesn’t make a lot of sense. The second problem is that this valuation technique didn’t help you at all during the recent bear market as the model said stocks were cheap all the way through.

However, the biggest problem with the idea of comparing valuations to interest rates is the technique falls apart when you go back in history. For example, this type of model has been on a screaming “buy” in Japan for more than 15 years. So, how would that have been helpful? Then here at home, the method doesn’t perform well when you go back in time. So, while this approach may be popular, we prefer valuation measures that stand the test of time.

Where does this leave us? While stocks will probably head higher during the first quarter as the celebration of an improving economy continues (imagine what would happen if we got some job growth!), we do have to recognize that valuations are becoming a little on the high side right now. Therefore, unless earnings and/or dividends can grow in a big hurry, we will probably need to play some defense at some point in 2010.

 

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