Despite the Selloff, the Market Still Isn't Cheap

After Tuesday's 4% gain in the S&P 500, do stocks still offer compelling potential returns for long-term investors?

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

The S&P now sells for 18 times earnings, based on yesterday's close of 1298 and $71.71 in trailing 12-month (TTM) earnings (according to Barron'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 = 29 times.)

However, market P/E ratios are partly influenced by the business cycle. For example, if 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 the average of the last several years' worth of earnings as their denominator. 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.

I updated the chart below to reflect Tuesday's close. The S&P fetches 23 times earnings on this basis, as the dark blue line shows. The pale blue line is the market's TTM multiple, which was closer to 19x after Tuesday's close. I want to thank Professor Shiller for permission to use this chart. Click here to learn more.

P/E Ratios vs. Long-Term Interest Rates

Click here for larger image.

Source: Robert J. Shiller

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

One other item to think about: Long-term rates, which are depicted in red, have trended down since September 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 Professor 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.

---

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit Earnings Power.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.