Stocks Are Not Cheap Or Expensive, But Are Priced Just Right; But They Still Have Significant Risk

Includes: SPY
by: Tony Abbate, CFA

Routinely I see stock market pundits saying given the low level of interest rates, stocks are cheap. Beware of these so-called market experts as they either are trying to sell you something or do not know stock market history. As the philosopher and poet George Santayana once said:

"Those who can't remember the past are condemned to repeat it."

I profess to have no ability to predict market movements. However, as history has shown, the stock market is very far from cheap. As of Friday, June 1st, the P/E ratio of the S&P 500 (NYSEARCA:SPY) Index stood at 14.8 times normalized adjusted earnings. (Note: Normalized adjusted earnings takes the price of the S&P 500 Index divided by the peak earnings over the past five years.) Since the end of 1937 stocks have sold on average at a P/E Ratio of 14. Hence, based on history, the current valuation of stocks are not too expensive or not too cheap.

Below is a chart illustrating the P/E Ratio (left axis) compared with the level of the S&P 500 Index from 1937 through the close on June 1st:

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You will notice there have been seven times since 1937 that stocks have bottomed below a P/E Ratio of 9.0. The late 1930s and 1940s coincided with a high level of uncertainty associated with World War II. The 1970s and early 1980s saw very high levels of inflation and interest rates. In the last few years, stocks reached a generational due to concerns about the sub-prime debt financial crisis. Right now the markets are dealing with a similar crisis around sovereign debt and the uncertainty it brings.

Below is a table that illustrates some of the macroeconomic events that have elapsed over the past 75 years and the change in valuation of the stock market:

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Do not get sucked in by the mantra that 'Stock Are Cheap'. As history has shown, during periods of crises and uncertainty, it is possible stocks could drop toward a single digit P/E ratio. If this happens, (I put the possibility at about a 20 percent probability) stocks would fall by 30 percent to 40 percent.

For investors with a time horizon of 10 years, stocks should generate a decent return compared with alternatives such as cash and bonds. Below is a table that illustrates the average 10-year return based on month-end P/E ratios from 1937 to 2011:

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You will notice an inverse correlation between stock market returns and valuations, or P/E ratios. The lower the P/E ratio, the higher the subsequent 10-year return. The higher the P/E ratio, the lower the subsequent 10-year return. Right now the stock market is priced at a level where from a historical perspective; stocks have delivered a 10-year average of 10.9 percent. The minimum 10-year annual return has been 3.9 percent when priced at the current P/E level. This is well above the 1.5 percent 10-year government bond yield.

These are unique economic and political times. If you understand history, you will not be convinced by the pundits who make the reckless claim stocks are cheap. Stocks are one of the most attractive places to put your money compared with cash and bonds. However, at these valuation levels, they do have significant downside risk. Investors need to be aware of this risk when making investment decisions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.