Stocks Are Cheap But Could Get Cheaper

8/22/2011


Among lessons the stock market has taught over the past century, one of the clearest is also among the simplest: Buy U.S. stocks when they are cheap.

With the S&P 500 Index down 12% since late July despite another mostly solid quarter of results, bulls argue the market is cheap today at 11 times expected year-ahead earnings — well below the long-term norm of about 17 times. The S&P 500 Index's forward earnings yield, or earnings/price ratio, has seldom been so attractive relative to bond yields.

Bears counter that such simple-minded comparisons are dangerous, with many making one or more of the following points:

The S&P 500 Index paints a misleading picture of the market's valuation. Because the index is capitalization-weighted, it is dominated by giant companies with huge stock-market values. And because shares of giant U.S. companies are unusually cheap today, the index's P/E is unusually low relative to the typical stock.

This argument holds some truth, as giant stocks have seldom been so cheap relative to the broad market. Excluding unprofitable companies and those with P/Es above 75, the largest 50 stocks in the S&P 500 have an average trailing P/E near 14, versus about 17 for all S&P 500 stocks. Since 1990 the top 50 have typically traded at a premium.

Still, robust profit growth and the market's recent slide have brought the typical U.S. stock to a comparatively modest valuation. Among the small, midcap, and large stocks in the S&P 1500 Index, the average stock has a trailing P/E near 19 — below the norm of 21 since the index's 1994 inception. Excluding the 2008-2009 bear market, the average S&P 1500 stock has never been as cheap as it was at the market's recent low on Aug. 10.

Moreover, on Aug. 10 about 102 stocks in the S&P 500 had P/Es below 10 while 162 had P/Es below 12 — well above the respective norms of 39 and 74 since 1992.


No. of S&P 500 Stocks With Trailing P/Es Between
0 and 10
10 and 12
12 and 14
14 and 16
0 and 16
Recent (8/10/2011)
102
60
83
77
322
Average since 1/92
39
35
47
52
173
High since 1/92
230
77
83
81
381
Low since 1/92
10
7
12
19
63

The median stock in the S&P 500 Index of large stocks trades at 14 times trailing earnings, meaning one-half of S&P 500 stocks have P/Es below 14. That is well below the norm of 18 since 1992 but above the March 2009 low of 10.

Some 102 S&P 500 stocks have P/Es below 10 — well above the historical norm of 39 but far below the March 2009 high of 230.


Corporate profits are unsustainably high, and earnings estimates are too optimistic. Profit margins have reached all-time highs, and year-to-year sales growth for the average S&P 500 company has rebounded to four-year highs above 12%.

Bears argue profit margins are more likely than not to begin reverting toward historical norms, especially with sales growth set to slow as U.S. stimulus spending winds down, Europe struggles to reduce debt with austerity efforts, and Asia confronts a drop in demand for its exports.

Based on the Shiller P/E, which compares stock prices to average inflation-adjusted earnings over the prior 10 years, stocks are slightly expensive relative to long-term norms. In other words, argue the bears, unless you believe the robust profits of recent years can be sustained, stocks are no bargain.

A few bullish retorts to this line of reasoning deserve mention. The financial sector suffered huge losses in 2008 and 2009, so average 10-year earnings may understate corporate America's earning power. Also, while several bellwethers recently issued disappointing guidance, 2011 and 2012 estimates for S&P 500 profits have edged higher since July 1. The consensus projects 15% growth for both 2011 and 2012.

Treasury bonds are overvalued and bond yields could jump sharply, so valuing stocks based on today's yields is foolhardy. If the economy gains some traction or inflation heats up, bond yields are likely to jump. But economic traction would be good news for earnings, and bond yields have a long way to rise to reach historical norms.

For the sake of argument, we compared the median earnings yield of S&P 1500 stocks to yields on Baa corporate bonds, which have not dropped as much as Treasury yields in the recent flight to safety. The median earnings yield exceeds the Baa yield by about 1.5%, roughly matching the 17-year high reached in March 2009.

If the median P/E returned to the 15-year norm of 18 (up from a recent 14.5) and the Baa bond yield returned to its 15-year norm of 7.1% (up from a recent 5.4%), the yield gap would be in line with historical norms.

Conclusion

Based on trailing and expected year-ahead earnings, the average U.S. stock is cheap versus 15-year norms. Relative to bond yields, the average stock is very cheap. But the bears are right to point out that, as always, everything depends on the outlook for earnings and interest rates.

Today's favorable valuation picture is one reason we're comfortable holding most of our equity portfolios in stocks, as we don't expect a huge market drop from present levels unless investors begin to anticipate a decline in corporate earnings. Still, considering today's downbeat economic news and the discouraging action in the market averages, such an outcome cannot be ruled out.

For now we're maintaining a partially hedged posture, with about 25% of equity portfolios in a short-term bond fund, while monitoring the outlook for earnings and bond yields.


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