Where to Find Value in a Pricey Market

The current P/E ratio is higher than 95% of all monthly observations in the past 35 years. And remember, this is occurring on peak profit margins. If you use long-term average profit margins, the median stock trades closer to 25 times normalized profits. So, again, that's not very cheap.

In fact, the actual current median valuation is much higher than it was in the fall of 2000. In October of that year, with the S&P 500 at 26 times earnings, the median P/E ratio of the largest 3,000 companies was only 14.0. At the last secular market top, the average stock was much cheaper than it is today!

Now, after all that ranting, here's my dirty little secret. Stocks are expensive, but they deserve to be. Conditions that affect share valuations are pretty close to ideal. Economic growth is neither too hot nor too cold. Inflation and interest rates are low. Corporate profits and, more importantly, free cash flows are at record high levels. Liquidity is abundant. It's no wonder share-repurchase programs, as well as M&A activity, are off the charts!

One day, maybe even soon, conditions will change. I don't need to list all of the things that could reverse the now-ideal conditions. The Cult of the Bear does that regularly. Heck, maybe even this column will inflame the gods of Booyah-ville and bring wrath upon shareholders all. But for this moment in time, circumstances support an expensive stock market. Just don't kid yourself that it's cheap.

So how do I handle conditions like this in my fund? I stay conservatively invested in individual situations that really do represent compellingly undervalued stocks. In 2003, when stocks were actually cheap, I espoused a shotgun strategy: Get market exposure all over, especially in mid- and small-caps. Today, I prefer rifle shots, mostly in the mid- and large-cap arenas.