What Does It Mean That Stocks Are Undervalued?

According to Robert Shiller's 10 year-moving average lagged price/earnings ratio, stocks are inexpensive. From Clusterstock:

As we've often noted, Shiller's valuation method--cyclically adjusted price-earnings [CAPE]--is one of only two long-term stock valuation measures that have meaningful predictive ability (the other is a measure of replacement value called "Tobin's Q"). CAPE averages 10 years of trailing earnings and thereby mutes the impact of the business cycle, which otherwise distorts price-earnings ratios.

For the past 17 years, according to Professor Shiller, stocks have remained persistently overvalued, sometimes violently so. In the past two months, however, they have finally fallen below their long-term average.

[click to enlarge]

This is the P/E of the stock market with a 10-year moving average of earnings in the denominator. For the first time in 17 years, it appears that stocks are undervalued. Accordingly, the long-term expected real return from equities is 6%-7%.

With stocks in a free-fall, it appears that the market is on its way towards a single-digit P/E.

Can the market trade at a 10-year moving average single-digit P/E again? Of course it can. Markets can do anything.

However, it is worth noting that the three times when stocks became egregiously undervalued were

• During the Depression, the most traumatic economic event of the century
• During World War II, the most destructive war of the century
• When interest rates rose to the highest level of the century

So, if form is anything to go by, to fall to a 10-year moving average P/E of less than 10x, this current economic event will have to be or lead to the biggest "something" of the century.

Comments

[prudentinvestor]

I can see using a 10-yr averaged E to value a stock, but only if I can buy and sell the stock at its 10-yr average price, and receive its 10-yr average dividend.

The more orthodox approach is to consider what is happening now. The S&P 500 E for 2009 seems to be in the $40-$45 range, which means that to get to single digit P/E, the index has to drop to about 400-450, a factor of two from current levels.

So, this recent mantra that stocks are cheap by historic norms is unconvincing.

2009 Jan 15 08:06 AM

[Donald Johnson]

Ten years ago, stocks were vastly over-valued. So I'm not sure what the 10-year-average has to do with anything.

Speculators have to look at the future, but when economists are saying the future is harder than ever to see, all we have is uncertainty. Uncertainty depresses markets. PEs and PEG ratios are useless because they're based on recent history and on unreliable forecasts for the next one to five years.

This means we have to trade the technicals and strive to protect capital, which is the most you can do in declining and trading market. The technicals say we're in a long-term bear market and a short-term correction of the recent bear market rally.

To buy for the long term at this point strikes me as about the biggest mistake you can make, other than the one the buy and holders made in 2007-2008.

2009 Jan 15 08:30 AM

[Conan the Barbarian]

I am one of the Buy and Holder's from 2007-2008.
Specifically, the CanRoys, which have upheld relatively well because of yields.

Way back when, there were quarters where the PE's on the Dow were negative. Buying on expectations that the E will be higher within 12 months can lead to good profits.

Buying before the E stops going down and the CEOs have expectations of worse is tantamount to Playing Keno or the Big Wheel in Vegas.

My watch has stopped, not to worry, it will be right twice a day.

2009 Jan 15 09:59 AM

[Larry House]

I like the "biggest something." That is exactly what we are in. Investors will have to be very patient here. Everyone wants to know if we have reached the bottom, when will we return to "normal," etc., etc. We are heading for a new "normal," that won't be just like the last one. It is going to take months and months if not years to get there. We have never been here before! Keep risk low and safety high.

2009 Jan 15 10:22 AM

[L Boyd]

I will not dispute the fact of whether or not stocks are "cheap". It should be noted that, while using the prior ten years' earnings do erase the effects of the business cycle, the past ten years have been somewhat of anomaly. Corporate earnings were fueled by consumer (and therefore business) spending based on ever increasing leverage. We got to the point that we were spending more than we were making, as a NATION! People were using low interest rates, via credit cards and home "equity" credit lines, to buy, buy, buy. This obviously couldn't go on forever (though it is very surprising, to me at least, how long the party did last) and we're now faced with a crash back to reality. It is highly doubtful that people will spend like they did over the past decade. In the near term we will probably see an "over correction" in consumer spending, but probably a much needed one. Are stocks historically "cheap"? Possibly; but I would take a look at the past ten years' earnings with a grain of salt.

2009 Jan 15 12:13 PM