Yuletide Gripings


Maybe I've been doing this for too long, but I find myself increasingly annoyed by what passes for stock-market commentary nowadays.

This year's prize for most annoying goes to the smug, smarter-than-thou bears who argue that owning stocks is foolish because the Shiller P/E ratio is higher than its long-term norm. Devised by Yale economist Robert Shiller, this ratio divides the price of the S&P 500 Index by the 10-year average of inflation-adjusted earnings.

In his book Irrational Exuberance, Shiller rightly argues that computing a P/E ratio based on one year of earnings can be misleading, since a single year may be unusually good or bad for corporate earnings. By using average earnings over a full business cycle, the Shiller P/E can help you avoid overpaying for stocks when earnings are near a peak.

Today the Shiller P/E is more than 21, above the norm of 17.5 since 1926 and the norm of 19.5 over the last 50 years. By comparison, if you use Shiller's data but substitute trailing one-year earnings for 10-year average earnings, the current P/E is near 17 — roughly equal to the norms since 1926 and since 1962.

The main reason for the more overvalued indication of the Shiller P/E is the massive earnings decline of late 2008 and 2009, which is depressing 10-year average earnings. In fact, if earnings from 2009 are excluded from the average, today's Shiller P/E of less than 20 is roughly in line with the 50-year norm.

Of course, excluding a year of bad results goes against the whole idea of the Shiller P/E, but it's worth asking whether the massive losses posted by the financial sector in 2009 are likely to be repeated. If not, 10-year average earnings are understating the true earning power of U.S. companies.

More fundamentally, capitalization-weighted indexes like the S&P 500 Index are not always the best way to measure the opportunities available in the stock market. After all, when the Shiller P/E and conventional P/E for the S&P 500 Index peaked in early 2000, the median P/E for U.S.-traded stocks was near a nine-year low. Outrageous valuations for big tech stocks and other big growth stocks were skewing the index's valuation.

Today big stocks trade at a modest discount to the broad market, on average. But the median P/Es for S&P 500 stocks and all U.S.-traded stocks are 5% to 10% below 20-year norms, and the number of stocks with low P/Es compares favorably to recent history. For example, as shown on below, 112 stocks in the S&P 500 have trailing P/Es below 12, higher than 84% of months since 1992 and well above the 20-year norm of 77 stocks.


Based on the number of cheap stocks available, the S&P 500 Index is attractive relative to 20-year norms. For example, 156 stocks in the S&P 500 have trailing P/E ratios below 14 — higher than the 20-year average of 126 stocks and higher than 75% of the months since December 1992.

Number Of S&P 500 Stocks
---------------With Trailing P/E Ratio ---------------
Below 10
Below 12
Below 14
Below 16
Above 20
Average since Dec. 1992
% of month-ends with
lower number since Dec. 1992

Also, even if you accept the logic behind the Shiller P/E completely, that does not mean the S&P 500 Index is certain to decline. Earnings growth could continue, or the P/E could climb. Remember, those who argue that stocks always return to a single-digit P/E are no more right than those who argue that P/Es always return to the mid-20s.

Dividend madness

Placing second for most annoying are dividend-oriented experts who brush off share-price drops, arguing that the declines enhance the dividend yield. Even worse: advisers who recommend making decisions based on the current dividend relative to the original price paid for a stock.

Once you buy a stock, your returns depend on the dividends you collect and the price at which you sell. Whether the current dividend equates to 2% or 20% of your original purchase price is irrelevant. Your decision to sell or hold should depend on your expectations for after-tax total returns — and the returns you expect from competing investments.

For example, if you bought one share of Procter & Gamble ($70; PG) 15 years ago at $28, the current annual dividend of $2.25 equals about 8% of your purchase price. That 8% number has no relevance to whether the stock should be held or sold. If you sell P&G for $70, you will be giving up $2.25 in annual dividends, equal to 3.2% of the selling price. To replace the income lost, you will need to reinvest the $70 in an investment yielding 3.2%.

We're on the wrong path

The bronze medal for most annoying goes to the doomsayers who argue America is on the wrong path — and therefore U.S. stocks are certain to crash. In a November poll by NBC, a majority of Americans felt the country was "seriously off on the wrong track."

After two wars and two recessions in the last dozen years, it's not surprising that Americans are pessimistic. What's surprising is that so many commentators make the jump from widespread pessimism to stock-market crash. Historically, periods of pessimism have been good times to buy; the worst times to buy have come at times of boundless optimism, when share prices typically reflect expectations for robust profit growth.

Moreover, while it is certainly possible that America has lost its moral compass or seen its best days of growth, that does not mean U.S. stocks are certain to crash. Nearly half of all revenue for S&P 500 companies comes from outside the U.S. And many sectors of the U.S. economy appear positioned for long-term growth, including energy, health care, and technology.

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