Stocks Are 'Cheap' On A Number Of Bases

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Includes: SPY
by: AddingAlpha

Stock valuations are attractive although the overall market is not.

We use short term Buy/Write strategies to generate income. In the past months, we have become cautious due to overall economic uncertainty. This includes the issues plaguing the euro zone, credit downgrades and spotty economic news. However, as investors we were torn as to investing or keeping large amounts of cash. We began looking at market valuation measures and found the following information.

Below we present some data in chart form courtesy of multpl.com.

The S&P 500 (S&P) P/E ratio is at 20.17 versus a mean/median of around 16, or more than 20% above historic middle data. This is an indication that the market is "cheap."

S&P 500 PE Ratio

S&P 500 PE Ratio Chart

S&P 12-month earnings per share — inflation adjusted, constant November 2011 dollars. This number is huge! Again an indication of value in the market.

S&P 500 Earnings

S&P 500 Earnings Chart

Although chart followers will see the obvious issues with the following, we are at a low level. Without getting into the problems and discussions of "inflation," the S&P is again "cheap" to the past 15 years.

S&P 500 Price, Inflation Adjusted

S&P 500 Price, Inflation Adjusted Chart

Dividends are key to our investment approach. As with the inflation adjustment above, the S&P is "cheap" relative to the past 15 years. When looking at this data, it is important to view dividend yield to an alternative, in this case Treasury yields.

S&P 500 Dividend Yield

S&P 500 Dividend Yield Chart

Our time horizon is typically short when we enter into a trade, 15-90 days. Because short term yields are nearly zero there is little value in looking at them. Furthermore, theories on stock valuations tell us that current stock yields represent the present value of future earnings. We do believe that these theories of valuation have merit and use longer term fixed income yields for comparisons. In this case we are looking at stock yields versus bond yields. Comparing stock yields to the 10 year Treasury is appropriate because each represents a long term horizon. There are many theories on how to value stock yields; we prefer to accept that they represent current value and that the stocks we buy represent a group that demonstrate stability. This stability is intended to mean stocks that have been around for a long time and are in stable, mature industries. 10 years therefore seems about right. Bellwethers of the past such as Kodak (EK), GM (NYSE:GM), and Citigroup (NYSE:C) have been replaced after a period of time. We view 10 years as about right for an average stock to perform at a level of stability.

With the S&P yield at 2.10% and the 10 yr at 1.8%, all seems good on a historic basis. A quick read tells us that mid/med for the S&P has been 4.3% while the same for the 10 yr has been 4.2%. This means that the S&P is "cheap" or conversely, bonds are rich. Either way, stocks have value in them on a yield basis.

10 Year Treasury Rate

10 Year Treasury Rate Chart

The conclusion is that as difficult as it is to leave cash, the stock market is "cheap."

In conclusion, stocks are "cheap" on any number of bases. The biggest challenge we have is getting over the recent market volatility and putting cash to work. This is something we will begin doing in the next few days. We will begin looking at our portfolios from a vantage point of what we would like to own versus what we do own. Going into year end it appears our current overweight cash position will be significantly reduced. Stock valuations are attractive although the overall market is not.

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