Answering The Biggest Question

7/23/2012


Regardless of the state of the economy, regardless of what the equity market has done lately, there is one question investors never stop asking. Are stocks cheap?

Given our human nature to seek out bargains, such a fascination makes sense. And given the reams of research showing that cheap stocks tend to outperform, that fascination can also make you money. So, back to the question. Are stocks cheap?

Let's look from two angles.

Start with individual stocks. The average S&P 500 Index component trades at 16.4 times trailing earnings, 7% below the five-year average of 17.7 for index stocks and more than 15% below averages over the last 10 years (19.4) and since 1994 (20.8). P/E ratios suggest stocks are cheap — but P/E isn't the only valuation metric.

The large-caps in the S&P 500 look somewhat cheap versus historical norms based on price/cash flow and roughly in line with most historical periods based on price/sales and price/book. The average Quadrix® Value score of 57 is better than the average for our Quadrix universe of nearly 4,500 stocks, but slightly below the large-caps' historical average.

MIXED BAG ON VALUATION RATIOS
The average S&P 500 Index stock trades at 16.4 times trailing earnings, a discount to historical norms for the index. Stocks look somewhat cheap on price/cash flow, while other valuation metrics are less conclusive.
Price/
Earnings
Ratio
Price/
Sales
Ratio
Price/Cash
Flow Ratio
Price/
Book
Ratio
Quadrix
Value
Score
Current
16.4
2.1
11.1
2.9
58
2-year average
18.2
2.1
11.5
3.0
59
5-year average
17.7
2.0
11.4
2.9
60
10-year average
19.4
2.1
12.3
3.1
61
Average since 1994
20.8
2.0
12.2
3.3
58

Then take in the big picture. The S&P 500's earnings yield (per-share earnings divided by index price) is 7.6%, well above the average of 5.6% since 1988. The earnings yield has remained at least 7% for four consecutive quarter-ends, a feat last managed in the year ended September 1989.

Factor in the state of bond yields, and the valuation picture brightens even more. At each of the last four quarter-ends, the S&P 500's earnings yield exceeded the 10-year Treasury bond yield by at least 4.8% and the yield of Baa-rated corporate bonds by at least 1.7%. To put that comparison in perspective, the earnings yield has averaged just 0.2% higher than the 10-year Treasury and 2.1% lower than Baa-rated bonds since 1988. Not in at least 25 years has the spread between the S&P 500's earnings yield and bond yields grown as wide as it has over the last four quarters.

These numbers lead to two conclusions.

1) Relative to its own history, the average stock looks somewhat cheap, if not exceptionally so. But we don't buy the average stock, and plenty of bargains are available.

2) Stocks as an asset class look very cheap relative to bonds, their No. 1 competitor for investors' money. Over time, earnings yields are likely to decline, leading to higher stock valuations — and higher prices.

Against that backdrop, stocks with attractive valuations look like excellent options. In the following paragraph we list the eight A-rated stocks with Value scores of at least 90 and price/earnings, price/sales, price/cash flow, and price/book ratios at least 10% below their 10-year average.

Recommended stocks: Aetna ($39; AET), Apache ($86; APA), Cisco Systems ($16; CSCO), and J.P. Morgan Chase ($39; JPM). Other A-rated stocks: Caterpillar ($82; CAT), ConocoPhillips ($56; COP), Halliburton ($29; HAL), and Valero Energy ($25; VLO).


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