Stocks Probably Aren't Cheap Anymore


The great news is that those of you brave enough to have caught the wave of surging stocks for the past two months have made a lot of money After Friday’s rally, eighth up week out of the last nine, the Dow Jones Industrial Average is up 31% above the March 9 lows. The Standard & Poor’s 500-stock index is up 37%.

The bad news is that there probably isn’t a lot of juice left in this rally. If you missed it, piling in now is a risky bet. By most measures, stocks aren’t “cheap” in the ways they were in the first few months of this year. Keep in mind, that almost all of the talk about stocks being cheap or pricey depends on stocks continuing to follow historical trends. If we’ve broken out of the historical pattern, then these measures are useless.

In today’s “Abreast of the Market” column for the Wall Street Journal, Tom Lauricella takes a look at several market measures to conclude that stocks are no longer cheap.

Shiller’s Normalized P/E Valuation Metric: Yale professor Robert Shiller, the guy whose name is attached to that house price index, also measures stock prices. He compares stock prices to a 10-year trend in earnings adjusted for inflation. The long-term view is thought to be a good one because it smooths out the cyclical pops and drops.

Back in March, normalized P/E ratio dropped toward 13. That was the lowest level since 1986, which suggested to many that stocks were “cheap.” As of last Wednesday, the normalized P/E has hit 15.9. This means stocks are priced about average, which means returns will be just around average. “However, I still think the market is risky right now,” Shiller tells Lauricella.

12 Month Tralining P/E Metric. The S&P 500 has price-to-earnings ratio of 14.7 based on trailing 12 month operating earnings. That’s up sharply from 10.5 in February. But it’s still below the average of 17 for the last 25 years. If this is your favoured metric, it suggests the rally might still have some upside.

Projected Earnings Metric. The S&P 500 is much closer to the 25-year average of 15 for forward looing P/E ratios. Last week it hit 14.5. Like the Shiller metric, this suggests that stocks are fairly priced. Bearish analysts, however, warn that earnings projections might be too rosy, which would throw this way off. On the other hand, you can still find bullswho will tell you that earnings projections have been pulled back to far. Lots of people think there’s just too much noise in this number to get a clear signal. 

“Last October and November, for example, the S&P 500 appeared to be extremely cheap on that basis, trading below a P/E of 11. But it turned out that analysts had wildly overestimated the earnings for the year ahead,” Lauricella writes. “Analysts had forecast 2009 S&P 500 operating earnings of $89 a share; that is now down to $57. But for 2010, the consensus calls for an almost 30% rebound.” (For more discussion of the problems with historical earnings metrics, check out Lauricella’s article.)

Current P/E Ratios. if you want to be scared straight out of the stock market, take a look at the current as-reported earnings. As May began, the S&P 500 was at a P/E of 131. That’s a record high, soaring above the long-term average a little less than 20. By this measure, stocks are ridiculously overpriced right now.



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