Is the Stock Market Cheap?

Doug Short of Advisor Perspective writes some of the most informative blogs on the web. His postings can be found at www.dshort.com. Today, Mr. Short shone the light on market valuation as the Dow Jones Industrial Average revisited the 14000 level for the first time since 2007.

The price to earnings ratio is of course one of the more common methods used to determine stocks and stock market valuations. However, since both prices and earnings can gyrate widely, the P/E ratio sometimes produces counter intuitive results. For example, during the market trough of 2009, the P/E ratio stood at triple digits, higher than the market peak of early 2000. Mr. Short's method of choice is the so called PE10, championed by Yale Professor Robert Shiller. Here is how he explains it:

Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected the 10-year average of "real" (inflation-adjusted) earnings as the denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.4. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.

According to Mr. Short, the current PE10 ratio falls within the top 20% group of the highest and is 34% above its historical mean of 16.5.

I started my career in the financial industry as a quantitative analyst. Our industry has an unrivaled ability to explain the past and an abysmal record at predicting the future. Ratios such as PE10 must necesarily move at such a slow pace to be basically useless for those with income to earn and moeny to invest. An individual investor simply can not sit on 0% return for years without losing patience and a professional one can not do so without jeopardizing his job.

On the question of market valuation, I happen to think the bulls and the bears are both right. Now before you start calling me names, let me explain.

As a financial asset of indefinite life, the value of a stock is determined by two things. First, its ability to earn a return now and forever into the future. Second, the prevailing interest rate now and forever into the future. Those who are pessimistic about stocks have assailed both of these front. Their arguments are based on what will happen in the future. They have argued that corporate profit margins are above historical average and are liable to fall to the mean. The prevailing interest rate is nothing but an anomaly manufactured by the brute force of the Federal Reserve. As sound as these arguments may be, it can not counter the mathematical reality of asset valuation. Stocks have been rising because corporate profits have been resillient and interest rates have stayed low. If T-bills will stay at 0% and 10 year Tresury will hold at 2% forever, then stocks are decided undervalued trading at a trailing PE ration of around 17. The fact is it makes a huge difference to the issue of stock market valuation whether the mean reversion envisioned by the bears arrives in 2 years or in 10 years. These days market participants have simply extended those said reversions toward a more distant future.

Is it more risky to sit on 0% return or to bet on your ability to foresee storms in the distant future?

Now that is a tough question.