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In our perennial quest to determine the future direction of the stock market, investors often ask the question of whether the market is currently overvalued, undervalued, or priced to perfection. To answer this question, many investors tend to examine prevailing P/E ratios compared to various historical average P/E ratios.

For instance, in a recent article by Mark Hulbert published on Marketwatch.com on Friday (“Dissecting the Stock Market’s P/E”), the current year P/E ratio for the S&P 500 stands at around 16, a touch higher than the historical one-year P/E average of 15.5 (which Mr. Hulbert arrives at using Professor Robert Shiller’s data going back as far as 1871). Mr. Hulbert also looks to the ten-year inflation adjusted P/E ratio for the S&P 500, which as he points out rests at closer to 23, dramatically higher than the long-term average of 16.4.

In his article, Mr. Hulbert concludes (or to be fairer, strongly suggests) that based on both P/E measures, the S&P 500 is currently overvalued, and as history suggests, purchasing shares of the S&P 500 at times when the market is overvalued is not the best investment strategy.

I’m going to suggest that Mark Hulbert, like many investors, uses a fundamentally flawed approach when it comes to measuring and using market valuation. The most glaring flaw in his approach is that as a practical matter, investing in the SPRD S&P 500 (ticker symbol SPY) based solely on the current year and ten-year inflation adjusted P/E ratios does not enable an investor to avoid taking losses or missing opportunities to earn profits.

For instance, both P/E ratios were plenty high back in the darkest hours of 2009, and if you stepped out of the market then because you thought stocks were too expensive, you’d have missed one of the most profitable investment opportunities ever. Quite simply, if an investment approach doesn’t earn you money, you should discard it.

Less importantly, as a conceptual matter, Mark Hulbert’s approach misses the fact that you cannot value stocks in isolation because in the real world, investors have investment alternatives other than stocks. P/E ratios, on their own, don't account for that.

Instead of looking at average P/E ratios as a litmus test for whether to invest in stocks or not, a better approach is to examine the market’s risk/reward outlook today verses other points in history, and to then ask “based on my own personal investment horizon, would I have made money had I invested in the market during time periods that offered me investment choices that are most similar to the one's I face today?”

Framing the issue thus seems better for both conceptual and practical reasons because it values stocks relative to other assets, and because the entire premise is based on what would have earned an investor money in the past.

Here’s an example of how the approach might work in practice. For purposes of this article (which needs to be brief), I’m just going to look at three historical data points, but a serious investor would want to consider many more years’ worth of data. I’ll look at three years in history that offered particularly attractive and particularly unattractive returns over about a ten year investment horizon, which is my own personal choice for a time horizon that I’m comfortable investing with. Other investors would want to use their own time horizons, but could still use the overall approach I’m going to illustrate right now.

Investing in the U.S. stock market back in 1968 would have produced nothing but 12 years of unprofitable misery for an investor. We see the S&P 500 stood in the range of about 95 to 100, a range which would not be broken until 1980.

Now, the Stern School at NYU publishes an online data page which offers a useful set of historical data which is titled “The Implied Equity Risk Premiums for the US.” Let’s see what that data show us about the market’s risk/reward proposition back in 1968. According to the data, the earnings yield for the S&P 500 in 1968 was around 5.51%. That was only modestly higher than the prevailing yield on a U.S. Treasury, which then stood at 5.21%. In 1968, investors were getting paid an exceptionally modest amount for taking the risk of investing in U.S. stocks as opposed to relatively low-risk U.S. Treasuries.

From a valuation perspective, the S&P 500 sported a P/E ratio of about 17, which doesn’t seem too shocking on its face, but investing in the market based on its P/E ratio would have been a dramatic mistake if your investment horizon was about ten years.

The smarter question for an investor to have asked was not whether the market was expensive in absolute terms, but rather, whether the rewards for taking market risk looked profitable in relative terms. Getting an extra .3% worth of earnings yield on stocks compared to Treasuries seems like a pretty paltry amount of compensation for stomaching the volatility of the equities markets, and for an investor like me, that implies the stock market was too expensive in 1968, and I would have done well to steer clear. If today is anything like 1968, it would be rational for me to do now what would have made me (or saved me) money then. Sell and run like hell.

Skip forward about ten years to 1976, when the S&P 500 stood at around 90, give or take depending on what day you were looking at. Investors who bought into the market at those levels would have endured a few years of zero to negative returns, but by 1986 would have more than doubled their money (not taking into account any reinvested dividends, which would have boosted returns considerably from there).

Now, what does NYU’s data show about stock market valuation in 1976? Here, we see an earnings yield of 9.07%, compared to a prevailing yield on a U.S. Treasury of about 6.81, which means investors would have been paid a handsome 33% premium for going into stocks instead of relatively low risk assets. In terms of valuation, the P/E ratio for the S&P 500 in 1976 stood at around 11, low in absolute terms, but again, that paints an incomplete picture since as an investor, I would have had investment choices other than equities back in 1976.

As a practical matter, I see that investing in the market back then based on the market’s risk/reward proposition would have worked well for me, and if today's risk/ reward proposition is anything like it was in 1976, I should do what would have worked for me then, unless things are different this time around.

Let’s fast forward again to 2001, probably one of the absolutely worst times for an investor to put money into the stock market. Here, we see an earnings yield of about 3.85%, compared to a yield of about 5.05% on a U.S. Treasury. Investors were actually PAYING to take risk in 2001, and paying a staggering 30% premium for that "privilege". To say stocks were overvalued in 2001 is quite the understatement.

Again, the P/E ratio for the S&P 500 was enormously high in 2001, but that misses the point. Paying to take risk just doesn’t make any sense – as history has shown. As a practical matter, staying out of the market in 2001 based on the market’s risk/reward proposition would have saved me a bundle of money over an 11 year time frame, and if today's risk/reward proposition in the stock market looks even remotely like it did in 2001, it wouldn't be insane for me assume I should do now what I should have done then. SELL, SELL, SELL, SELL!!!!!! Unless, that is, it's different this time.

Having looked at some historical examples of when the market would have delivered rewards verses a sharp stick in the eye to an investor with my investment horizon and risk appetite, let’s now turn to the salient question of the day, which is whether or not now is a good time to invest in stocks. Again, as Mark Hulbert's article shows, the P/E ratio for the S&P 500 nowadays is about 16, which looks more like 1968 than it does 1976, but fortunately nowhere near the seemingly implausible P/E ratio of 30 we saw in the S&P 500 back in 2001.

But since investing in the market based entirely on prevailing P/E ratios wouldn’t have earned me money in 1968, 1976 or 2001, I’ll assume it won’t do much for me today either. Instead, I’ll look at what would have actually worked for me, which is the market’s valuation in relative terms. Again, in real life, I’d want to look at many other years’ worth of examples besides those three years, but the purpose of this article is to just illustrate an investment approach, not to draw any firm conclusion about whether investors should step into the market or not.

Today, the earnings yield on the S&P 500 stands at about 6.3%, compared to the almost laughable 2.986% I could get if I just bought a ten-year U.S. Treasury. The premium I get for enduring the dubious pleasures of investing in stock is over 100%, which is several times higher than the premium I would have earned had I invested in stock back in 1976.

From an absolute perspective, equities today seem pricey, but from a risk/reward perspective, we seem to be far closer today to where risk pricing stood in 1976, rather than 1968 or 2001. And if 1976 is a closer analogy of where we stand today, I can conclude that since going into the market back then would have worked for me, it stands a chance of working for me this time around, unless there’s been a fundamental change since then.

Has there been a fundamental change? The answer to that question is beyond the scope of this article, but I think it’s important to note that the Fed’s QE1 and QE2 programs knocked interest rates into almost unthinkably low ranges. So low, in fact, I think there’s a really good chance that “normal” market conditions are not necessarily prevailing at the moment, and U.S. Treasuries may be in a price bubble. If so, I’m not comfortable calling the yield on U.S. Treasuries “risk-free”, and thus, I cannot conclude that equity risk premiums are anywhere close to 100%. But I do see that interest rates for U.S. Treasuries would have to suddenly double at a time when corporate profits stagnate or go into reverse, before we see the equity risk premium drop down to where it was in 1968. And that scenario doesn’t seem likely today – which is the day when I have to decide whether to buy, hold or sell my stock portfolio.

Source: The S&P 500's P/E Ratio Is a Red Herring