Are Stocks Cheap Right Now? If So, Which Ones?

Every investor knows to buy low, but how do you make an educated guess about whether a stock is near the bottom or has further to fall? Plus: 5 stocks that look like bargains.

Are stocks cheap now?

That's the question investors inevitably ask after a drop like the one we've seen since the Standard & Poor's 500 Index ($INX) hit a high at 1,217 on April 23. From that high through the close on July 2, the index dropped almost 16%, though it's made a bit of a comeback this week.

Attempts to answer that question almost always haul out historical comparisons. Stocks are cheap, because they trade at price-to-earnings ratios that haven't been seen since woolly mammoth futures traded on the LME (London Mammoth Exchange). Or they're expensive, because in decades when interest rates are rising stocks have historically traded at price-to-earnings ratios of the inverse of the second derivative of the change in the yield of 10-year Treasurys (or something like that).

I think that kind of historical number will get you partway home. It will give you a probability that stocks in general are cheap or that a stock in particular is cheap. That's not a guarantee that a stock won't be cheaper tomorrow, but it is a useful read on how likely it is that you are buying somewhere in the neighborhood of "cheap" or "fairly valued" or "expensive." Cheap? Or getting cheaper? To get you closer to a complete answer, though, I think you need to ask a second question: When we ask, "Are stocks cheap?" what exactly do we mean?

Combine the two approaches, and I think you can come up with a pretty good answer. Right now, I'd say, the answer is mixed. Some stocks are cheap. Others are moving in that direction. Let me explain how to tell which stocks are which.Msn.Video.createWidget('PlayerAd1Container', 'PlayerAd', 300, 213, {"configCsid": "MSNmoney", "configName": "player-money-articles-16x9", "player.vcq": "videoByUuids.aspx?uuids=63b5f33c-a037-431c-871f-eff55572fac1,ba40b863-2856-4f71-8c7e-0298819c26fd,46642c08-2898-4d4b-8038-12a55599605c,81af29e2-3151-4c57-8ad2-d9720f2c7642,ac742840-b1bc-495a-bd1d-bcd79166e940,1e017457-6e6b-4d4f-91c6-45e14c1e7b13,ca47912f-3a77-4248-ba2b-1bf33c385dcb,0f168c58-c6e0-e688-a5d2-dcfbecd3aa8e,c8c30588-7f97-46ab-87f7-66d618c4d494,e81710b1-119c-4849-9098-129006d8c15f,e88e6ae7-f12e-4350-8889-86e3baaaa755,e2ce750c-be1d-418d-9b83-23c9e02bbab1", "player.fr": "iv2_en-us_money_article_16x9-Investing-JubaksJournal"}, 'PlayerAd1');Msn.Video.createWidget('Gallery4Container', 'Gallery', 304, 150, {"configCsid": "MSNmoney", "configName": "gallery-money-articles", "gallery.linkbackLocation": "bottom_left", "gallery.numColsGrid": "3", "gallery.categoryRequests": "videoByUuids.aspx?uuids=63b5f33c-a037-431c-871f-eff55572fac1,ba40b863-2856-4f71-8c7e-0298819c26fd,46642c08-2898-4d4b-8038-12a55599605c,81af29e2-3151-4c57-8ad2-d9720f2c7642,ac742840-b1bc-495a-bd1d-bcd79166e940,1e017457-6e6b-4d4f-91c6-45e14c1e7b13,ca47912f-3a77-4248-ba2b-1bf33c385dcb,0f168c58-c6e0-e688-a5d2-dcfbecd3aa8e,c8c30588-7f97-46ab-87f7-66d618c4d494,e81710b1-119c-4849-9098-129006d8c15f,e88e6ae7-f12e-4350-8889-86e3baaaa755,e2ce750c-be1d-418d-9b83-23c9e02bbab1;videoByTag.aspx%3Ftag%3Dmoney_dispatch%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1;videoByTag.aspx%3Ftag%3Dbest%2520of%2520money%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1"}, 'Gallery4');The problem with attempts that use historical data to answer "Are stocks cheap?" is that the answer depends to a disappointingly large degree on the assumptions you make about the future.

So, for example, at the end of June, Birinyi Associates reported that over the past 20 years, the average trailing price-to-earnings ratio for the S&P 500 is 20.3. On June 29, the trailing P/E for the index was just 15.6.

Ergo, stocks are historically cheap.

Absolutely true. But not totally helpful. Stocks may be cheap if you look at trailing earnings -- earnings per share over the past 12 months -- but that doesn't tell us anything about whether they're cheap on future earnings. And future earnings determine tomorrow's price for the stock you buy today.

And that's especially true right now, as fear that a slowing global economy is going to take a bite out of future earnings is driving down stock prices.

So what do data on future earnings (aka "forward earnings") and future price-to-earnings ratios tell us? Again, that stocks are cheap. The forward four-quarter P/E ratio for the S&P 500, according to Thomson Reuters, is just 12.7. That's below the past year's average forward P/E ratio of 14.4.

But that data leave us in exactly the same place. Stocks are cheap -- if analysts' projections of future earnings are correct. If the global economy is slowing, then the projections are wrong, and so is the conclusion that stocks are cheap.

You can massage this data in lots of ways. You can take into account current interest rates -- and the projected direction of interest rates. You can factor in where the market stands in the economic cycle. You can try to correct earnings numbers and projections to come up with what's called normalized earnings, which look at what a company's earnings power will be once the "unusual" economic condition is over.

All those are useful, but they run into the same problem: They rest on some projection about the future. And it's the current uncertainty about the future that is driving investors to sell and to wonder whether they shouldn't instead be buying.

I don't advise throwing out all these historically based attempts to answer the "Are stocks cheap?" question. They can be very useful if you recognize that instead of giving you a concrete yes or no, they give you a probability. Knowing that stocks trade at a trailing price-to-earnings ratio of 15.6 when the average over the past 20 years has been 20.3 doesn't guarantee that stocks can't get cheaper or that they're about to rally because of this low valuation. Instead, it tells you that in the most common economic situations -- those that occur, say, two-thirds of the time -- buying now will be buying at a bargain price.

And that's a useful context. Keep it in mind, and then turn your approach to the question on its head by asking not "Are stocks cheap?" but "What do I mean by cheap?"

Continued: Define 'cheap' More from MSN Money

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So, for example, at the end of June, Birinyi Associates reported that over the past 20 years, the average trailing price-to-earnings ratio for the S&P 500 is 20.3. On June 29, the trailing P/E for the index was just 15.6.

Ergo, stocks are historically cheap.

Absolutely true. But not totally helpful. Stocks may be cheap if you look at trailing earnings -- earnings per share over the past 12 months -- but that doesn't tell us anything about whether they're cheap on future earnings. And future earnings determine tomorrow's price for the stock you buy today.

And that's especially true right now, as fear that a slowing global economy is going to take a bite out of future earnings is driving down stock prices.

So what do data on future earnings (aka "forward earnings") and future price-to-earnings ratios tell us? Again, that stocks are cheap. The forward four-quarter P/E ratio for the S&P 500, according to Thomson Reuters, is just 12.7. That's below the past year's average forward P/E ratio of 14.4.

But that data leave us in exactly the same place. Stocks are cheap -- if analysts' projections of future earnings are correct. If the global economy is slowing, then the projections are wrong, and so is the conclusion that stocks are cheap.

You can massage this data in lots of ways. You can take into account current interest rates -- and the projected direction of interest rates. You can factor in where the market stands in the economic cycle. You can try to correct earnings numbers and projections to come up with what's called normalized earnings, which look at what a company's earnings power will be once the "unusual" economic condition is over.

All those are useful, but they run into the same problem: They rest on some projection about the future. And it's the current uncertainty about the future that is driving investors to sell and to wonder whether they shouldn't instead be buying.

And that's a useful context. Keep it in mind, and then turn your approach to the question on its head by asking not "Are stocks cheap?" but "What do I mean by cheap?"

Continued: Define 'cheap' More from MSN Money

 1 | 2 | next >

Check out Jim's top stocks for the next 12 months.

Read how to invest with Jubak's showcase portfolio.

Follow the long-term portfolio from Jim's book "The Jubak Picks."

See Jim's new portfolio to help navigate the treacherous interest-rate environment.

Read Full Article »