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After a six-month rally, U.S. stocks are getting pricier. Experts say investors should exercise caution.
The Standard & Poor's 500-stock index gained 12% during the first three months of 2012, the best start to the year since 1998. After this week's 0.7% drop, the benchmark index has run up a stunning 27% since Oct. 3. Despite the surge, some strategists argue that stocks are still cheap, based on comparisons with bonds.
More traditional measures, however, suggest stocks at best are fairly priced, and at worst are worryingly expensive. With corporate earnings growth slowing in the U.S. and renewed fears of a European meltdown, some strategists say stocks are due for a rough stretch.
"There's a lot of uncertainty out there, so the S&P shouldn't be trading at a premium," says Stuart Kaiser, an equity strategist at Goldman Sachs Group (GS) . "The idea that equities are cheap is not quite right when all factors are considered."
Take the price/earnings ratio, the standard valuation metric, which is calculated by dividing a company's stock price by its earnings per share. It gives investors a rough idea of what they are paying for each slice of a company's profits.
When the number is high, stocks are said to be expensive; when it is low, equities are said to be cheap.
The cyclically adjusted P/E ratio, which uses 10 years of profits to make the calculation, is about 22, well above its long-term average of about 16. While the current level is lower than at the peaks of 2000 and 2007 -- one a bubble, the other fueled by easy money -- it is about where it was when the stock market peaked in 1966, just before entering 16 years of essentially flat performance.
The richness of U.S. stocks appears even starker when compared with stocks in other developed markets, says Richard Cookson, chief investment officer at Citi Private Bank in London. The 10-year P/E in Germany and France, for instance, is about 12.
Some of that gap between U.S. and European stocks is justified; Europe is working to avoid the dissolution of its currency union and might already be in recession, while the U.S. economy is showing signs of improvement.
Still, such extreme differences rarely have been good for investors in U.S. stocks, Mr. Cookson says. The gap between U.S. valuations on the one hand and German and French valuations on the other is currently 9.6 percentage points, well above the 120-year average of 1.7 points.
When the gap has been as wide as now, European stocks have beaten U.S. shares by 14.5 points during the following 12 months.
"U.S. equities should trade at a premium to Europe," Mr. Cookson says. "But investors are paying through the nose for safety."
To be sure, the market looks cheaper based on shorter-term profit data. Using earnings from the past 12 months, the companies in the S&P 500 have an average P/E ratio of about 14, below the average of about 17 since 1930. Using analyst forecasts of earnings for the next year, the P/E ratio is about 13.2, below its median of 13.8 since 1976.
But even on this basis, the market's valuation might be near a ceiling. During the past two years, every time the forward P/E has risen above 14, some sort of crisis -- whether a growth scare in the U.S. or fears of a euro-area dissolution -- has knocked it lower.
To warrant a higher P/E now, investors would have to believe those fears are a thing of the past, says Adam Parker, chief equity strategist at Morgan Stanley (MS) .
Many analysts assume the current low-interest-rate environment will force investors into riskier assets such as stocks. Historically, that hasn't always been the case, Mr. Parker says. Since 1930, the average P/E has been 11.3 when real rates -- that is, the 10-year Treasury minus the rate of inflation -- have been below zero, according to Mr. Parker. The 10-year real rate is currently minus-0.08%.
"You have to believe the economy is improving and that rates will normalize to pay higher multiples," Mr. Parker says.
That means investors should take a more cautious approach to stock investing, favoring companies with strong balance sheets and consistent earnings, experts say.
Even though dividend payers were among the most popular stocks in 2011, some look cheaper than they were a year ago. The WisdomTree Dividend ex-Financials (DTN) exchange-traded fund, for example, has a P/E of 15, down from 16.3 a year ago.
Investors looking for individual stocks should consider health care, energy and tech stocks with above-average dividend yields, says Mark Luschini, chief investment strategist at Janney Montgomery Scott. Even after the rally they look reasonably priced, he says. His picks include energy-giant ConocoPhillips (COP), medical-device manufacturer Medtronic (MDT) and software titan Microsoft (MSFT) .
"The markets aren't giving anything away anymore," Mr. Luschini says. "But high-quality dividend payers are better than the alternatives in the U.S."
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