Where to Find Value in a Pricey Market

I can't believe my ears! On CNBC, talking head after talking head is asserting that stocks are cheap. Stocks have gone nowhere for seven years and earnings have doubled, so stocks must be cheap. Interest rates are low, so stocks are cheap. Private-equity firms are buying like crazy, so stocks must be cheap.

Give me a break. Stocks are absolutely not cheap. This column will show why and explain how a value investor deals with such a market, and also give you some stocks to check out for your own portfolio.

The most common rationale for the cheap-stock contention is the S&P 500's 15.5 price-to-earnings ratio on consensus 2007 earnings estimates. However, the S&P 500 is not the market. The index includes a disproportionate chunk of energy and financial stocks, which chronically trade for 10 to 12 times earnings. Removing them reveals an industrial component at 20 times trailing and about 18 times estimated 2007 profits. That's not cheap.

It gets worse. Profit margins, the cyclical and most important component of a company's earnings stream, are at peak levels. That's correct: We have very high P/E ratios on historically unsustainably high profit margins. Few market commentators acknowledge this. One wonders if they even understand it. Even the bullish few who get this contend that it's different this time. To which I can only reply, "Repeal the business cycle? Ha!"

Another way to measure the valuation of stocks is to look at a broader slice of the market. I prefer this method to using a mega-cap-weighted index like the S&P 500. According to two different sources, the excellent Leuthold Group and Value Line, the median P/E ratio of the largest 3,000 companies is 20.5 times trailing earnings.