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This column for was published last week. It also includes a chart I created, which unfortunately doesn't paste. So, you will have to go to Prof. Shiller's website, which is here For RM subscribers the link is here:

Despite the Selloff, the Market Still Isn't Cheap

By Hewitt Heiserman Contributor
3/20/2008 10:40 AM EDT

With Tuesday’s 4% gain in the S&P 500, do stocks still offer long-term investors compelling prospective returns?

One way to answer this question is to look at the market’s price-earnings ratio. P/E’s tell us how much investors are paying for earnings. The lower the P/E, the more value you get in return—provided, of course, these earnings hold steady or improve.

The S&P now sells for 19 times earnings, based on yesterday’s close of 1331 and $71.71 worth of trailing twelve month’s earnings (source: Barrons’s). With the benchmark 10-year Treasury selling at 29 times earnings, large-cap stocks are more attractive than bonds, on this basis. (A bond’s multiple is the reciprocal of its yield; e.g., 1/3.46 = 29x.)

Market P/Es are partly influenced by the business cycle, however. If, for example, top-line sales are roaring and profit margins are at a peak, then stocks may look cheap even if we are on the cusp of a recession. By the same token, the market will look expensive if corporate America is hurting, even if the economy is about to strengthen.

To mitigate these distortions some analysts use as their denominator the average of the last several years’ worth of earnings. Rolling-period earnings have the advantage of smoothing out the economy’s year-to-year vagaries.

Yale Professor Robert J. Shiller, for example, uses the average of the last ten years worth of inflation-adjusted, or “real,” earnings to estimate a market P/E. The S&P fetches 23 times earnings on this basis, as the dark blue line in the chart below shows. The pale blue line is the market’s TTM multiple, which is 19x as mentioned above. I want to thank Professor Shiller for permission to use this chart, which I updated to reflect yesterday’s close. To learn more, go here:

The lesson of this chart is that while the S&P is a lot less expensive than the Himalayan levels of 2000, at 23x it is still not cheap. Indeed, 127 years of stock market history shows just three other times when real 10-year PE’s breached current levels: 1901, 1929, and 1966. In each instance, the multiple later contracted to below 10x. Mean regression can hurt!

One other item to think about. Long-term rates, which are depicted in red, have trended down since Sept. 1981, when they hit 15.3%. The decline in the cost of capital was a tonic for stocks, igniting an 18-year bull market.

But with the 10-year Treasury now down to 3.46%, further gains from these levels seem unlikely, barring a depression. Indeed, with the exception of a few months in 2003, long bond yields haven’t been this low since the Eisenhower Administration. If rates climb back to 4.7%, which is the median yield since 1881, then bonds will offer more value than stocks.

My interpretation of Prof. Shiller’s research is that the stock market will tread water for several years until earnings catch up—with plenty of white-knuckle episodes along the way. Thus, if you are a long-term investor, buy companies that 1) possess authentic earnings power, 2) enjoy a durable competitive advantage, and 3) trade at a discount to intrinsic value, as I describe in my book It’s Earnings That Count. Also, update your portfolio mix, if necessary. Stocks as an asset class are not always the best investment.
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