Neither Cheap Nor Expensive
2/11/2013
When Winston Churchill warned his readers that these "are the opinions on which I base my facts," he had issues weightier than stockmarket commentary in mind. But his disclaimer is worth remembering as you consider the arguments of bulls and bears — even on seemingly objective questions like whether stocks are cheap or expensive relative to earnings.
P/E RATIOS FOR S&P INDEXES


Average P/E Using
 Trailing Earnings  
Average P/E Using Estimated
 Forward Earnings  

Recent 
3 Years 
5 Years 
10 Years 
Recent 
3 Years 
5 Years 
10 Years 

S&P SmallCap 600 Index


Capitalization Weighted 
19.5 
19.5 
19.0 
20.0 
16.5 
15.7 
15.6 
16.1 
Equal Weighted 
19.6 
20.5 
20.1 
20.6 
16.6 
16.0 
16.0 
16.0 
S&P MidCap 400 Index


Capitalization Weighted 
17.3 
17.5 
16.7 
17.7 
15.9 
14.9 
14.5 
15.3 
Equal Weighted 
17.5 
17.3 
16.6 
17.4 
15.8 
15.0 
14.6 
15.2 
S&P 500 Index (largecap)


Capitalization Weighted 
14.5 
14.5 
14.9 
16.4 
13.4 
12.6 
12.8 
14.4 
Equal Weighted 
16.3 
16.5 
17.8 
18.1 
15.1 
14.3 
14.1 
15.0 
Bulls argue the market is clearly cheap, as the S&P 500 Index trades at 14.5 times trailing earnings — more than 11% below the 10year norm of 16.4 and lower than 75% of monthends over the past 10 years. Bears often counter with one of the following five arguments:
1) Trailing earnings are yesterday's news, and stocks don't look as cheap relative to historical norms using expected yearahead earnings.
Our take: This argument holds some water, as the S&P 500's discount to 10year norms narrows to 7% based on yearahead estimates.
2) Capitalizationweighted indexes like the S&P 500 skew the market's P/E lower, since big stocks are unusually cheap relative to the broad market.
Our take: This argument is also valid, especially on a forwardlooking basis. The equalweighted S&P 500 trades at a small premium to 10year norms based on yearahead earnings, as do smallcap and midcap indexes.
3) P/E ratios based on one year of earnings can be misleading, and the S&P 500 is expensive based on 10year average earnings.
Our take: Based on the Shiller P/E, which uses average 10year inflationadjusted earnings, the S&P 500 trades at a multiple of 23 — above the norm of 19.5 since 1960. But 10year average earnings are being skewed lower by huge losses in the financial sector in 2008 and 2009. While considering average 10year earnings is a useful exercise, some bears appear guilty of using the Shiller P/E too dogmatically. Remember, share prices discount the future, and stocks won't become cheaper in 2019 simply because the depressed earnings of 2009 no longer figure in 10year average earnings.
4) Ten years is too short a period for valuation comparisons.
Our take: This statement is undeniably true, but stocks are not particularly expensive relative to longerterm norms. The average S&P 500 stock trades at a 9% discount to the norm since January 1991. Using Shiller data but substituting trailing oneyear earnings for 10year average earnings, the S&P 500 Index trades at a 5% discount to the norm since 1960.
5) Profit margins are unsustainably high, so earnings are inflated.
Our take: Margins are undeniably high relative to longterm norms. But with wage growth sluggish because of slack in the labor market, it's not clear why margins would narrow anytime soon.
P/Es vs. 10YEAR NORMS


Recent 
10Yr. Norm 
Recent As % Of Norm 
% Of Mos. With Lower P/E 

Trailing P/E ratio 

S&P SmallCap 600 Index 

Cap Weighted 
19.5 
20.0 
97 
47 
Equal Weighted 
19.6 
20.6 
95 
41 
S&P MidCap 400 Index 

Cap Weighted 
17.3 
17.7 
98 
34 
Equal Weighted 
17.5 
17.4 
101 
45 
S&P 500 Index (largecap) 

Cap Weighted 
14.5 
16.4 
89 
25 
Equal Weighted 
16.3 
18.1 
90 
19 
Forward P/E ratio 

S&P SmallCap 600 Index 

Cap Weighted 
16.5 
16.1 
102 
56 
Equal Weighted 
16.6 
16.0 
103 
67 
S&P MidCap 400 Index 

Cap Weighted 
15.9 
15.3 
104 
61 
Equal Weighted 
15.8 
15.2 
104 
66 
S&P 500 Index (largecap) 

Cap Weighted 
13.4 
14.4 
93 
34 
Equal Weighted 
15.1 
15.0 
101 
45 
Conclusion
Stocks are not particularly cheap or particularly expensive relative to longterm norms. But the S&P 500 Index's P/E has been meaningfully higher than current levels at all of the bullmarket peaks since 1946. Relative to today's bond yields, P/E ratios are quite low.
Subscribers should maintain a mostly invested posture, emphasizing attractively valued growers. Our Buy List and LongTerm Buy List, both of which have an average trailing P/E of 13 and forward P/E of 12, have 91% to 97% in stocks.