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Mark Hulbert
June 3, 2011, 12:01 a.m. EDT
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” Are stocks undervalued?
That's an important question to ask at any time, but especially right now "” as the stock market struggles to find a bottom in a correction that so far has taken more than 600 points off the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed DJIA -0.34% .
Unfortunately, it's hard to slice and dice the data in a way that shows stocks to be undervalued right now.
Are stocks heading for a further decline? MarketWatch columnist Mark Hulbert says investors can glean some clues by looking at the price-to-earnings ratio of the S&P 500 in relation to its historical average. Interview with MarketWatch's Laura Mandaro in San Francisco.
Let me present the data, and then respond to some of the ways in which investors recently have been trying to wriggle out from underneath the sobering conclusion the data are painting.
Let's start with the current P/E for the S&P 500 index /quotes/comstock/21z!i1:in\x SPX -0.12% , which stands at 16.1 when calculated using trailing 12-month as-reported earnings. This is about 5% above the long-term average for this ratio back to 1871, which is 15.5 according to data supplied by Yale University finance professor Robert Shiller.
To be sure, the one-year P/E ratio is quite volatile, and its track record is rather mixed. For this reason, many researchers have followed the lead of Shiller and Harvard professor John Campbell and focused on a modified P/E ratio whose denominator is average inflation-adjusted earnings over the trailing 10 years. This modified ratio is sometimes called CAPE (for Cyclically Adjusted Price Earnings ratio). The CAPE has a markedly better forecasting record than the simple P/E.
The current CAPE, according to Professor Shiller's data, is 22.7.That's 38% higher than this modified ratio's long-term average of 16.4.
On both counts, therefore, it's hard to argue that stocks are undervalued. And, at least when focusing on the CAPE, it actually looks as though stocks are downright overvalued.
How do the bulls respond? There are three arguments that I have come across, and let me offer a couple of responses to each:
"The P/E ratio would come down if we focused on forward rather than trailing earnings." My response: Of course it would, but then you no longer can compare it to the historical average level of 15.5, which was calculated using trailing earnings. An apples-to-apples comparison to a forward-based P/E would with the average of past forward-based P/Es "” and, since analysts are perennially bullish, that average would be a lot lower. In fact, according to Cliff Asness of AQR Capital, the median forward-looking P/E is nearly 25% lower than the median trailing-looking P/E.
"We should be focusing on just the last 50 years rather than the last 140, and the current P/E is well below-average relative to the last 50 years." My response: But why is the last 50 years more relevant? It's trendy to just assume that it is, but few actually subject that assumption to critical scrutiny. A compelling argument can be made that recent decades are, if anything, actually an unhelpful basis for comparison "” since they represent the apex of the Pax Americana era in world history. After all, it's quite unlikely that the U.S. will enjoy the same degree of geopolitical hegemony and financial power around the world over the next 50 years as it did over the last 50. For example, do you really think the U.S. dollar will play the same role in the global economy over the next five decades as it has since World War II, conveying the same degree of future economic benefit to the United States?
"The CAPE might have a good track record in prior decades, but it paints an unfairly bleak picture today, since the last decade included two severe economic recessions." My response: There have been a number of decades over the last 140 years in which there were two recessions, so the last 10 years are not unprecedented in that regard. In any case, there other ways besides the Campbell/Shiller approach to "cyclically adjust" or "normalize" year-to-year earnings, and P/E's calculated using those alternate earnings adjustments don't necessarily paint a more bullish conclusion. Ned Davis, for example, of Ned Davis Research, recently developed a linear regression model to calculate normalized earnings, and found that a P/E based upon those normalized earnings was well above average.
To be sure, the market's short-term prospects are not doomed just because valuations don't show stocks to be undervalued. That's because P/E ratios exert only a weak gravitational pull over the market's shorter-term direction.
Still, it would have been encouraging if the P/E ratio did show the stock market to be significantly undervalued, since in that case, valuations would have provided a floor under the market that could have reduced the downside vulnerability. Unfortunately, though, that is just not the case.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.
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