Question: What is the current price-to-earnings ratio of the S&P 500?

Answer:

    16.3

    18.0

    19.8

    All of the above

    The correct answer is D. That's right, the S&P 500 trades for 16.3, 18.0 or 19.8 times estimated 2007 earnings. How can that be?

    Well, there are four different ways to look at the S&P 500's P/E ratio. The most commonly used method sums up the market value and net income of all 500 companies and divides them. That gets us the 16.3 multiple on a $14 trillion market cap divided by $864 billion in estimated 2007 profits. But this calculation treats the index as one company. Do you view the S&P 500 as one company with 500 subsidiaries?

    To get a fairer picture of the average P/E ratio of a 500-stock portfolio, which is what the index represents, one must calculate it differently than simply summing market caps and earnings. Plus, looking at the S&P 500 as a portfolio of stocks generates meaningfully higher valuations. With this methodology, the median P/E is 18.0, the mean P/E is 19.8, and the market-cap-weighted P/E is 18.0.

    Clearly, the average stock in the S&P 500 is not trading at 16.3 times 2007 earnings. That 18 or 19 target advocated by most talking heads already exists, both in the S&P 500 as well as a broader index, the Value Line Arithmetic Index.

    Digging a bit deeper, I calculated the valuations excluding the top 10 net income stocks. Everyone knows that a handful of big, cheap, ugly stocks such as

    General Electric

    (GE) - Get General Electric Company (GE) Report

    ,

    AIG

    (AIG) - Get American International Group, Inc. Report

    and

    Exxon Mobil

    (XOM) - Get Exxon Mobil Corporation Report

    are pulling down valuations.

    So I removed them and did the same calculations for the S&P 490. The mean and median levels did not change much, as one would expect. But the market-cap-weighted P/E rose to 19.0 times estimated 2007 earnings. Now

    that

    feels more like the stock market I know and love.

    I also calculated the profit margins for the index in the same manner as I did valuations. In every observation, profit margins are 15% to 20% above 10-year average levels. Since margins do mean-revert, it would not be unfair to normalize them lower to average levels. If you wanted to be a real pessimist, you could arguably contend that the S&P 500 trades for 25 times estimated, normalized profits.

    So, despite what the talking heads maintain, the vast majority of stocks are already at high-teen P/E ratios. They might be "rationally expensive," as I have

    written in the past, but they are not cheap, 15-to-16 P/E stocks. Herein lies the silver lining.

    Because the average stock is so expensive, fair valuation upside for an average company is much higher than most people realize. When investors revalue a cheap stock into average valuation territory, it doesn't have to stop at the S&P 500's 16 multiple. Rather, it can continue up to the high-teen P/E level, which is where the average stock resides today.

    For this reason, many investors and analysts shortchange their company price targets and sell too soon. Or they underestimate the upside potential of a cheap stock and choose to avoid it. Either way, money is not made when it should be. When a formerly cheap stock gets some love from investors for whatever reason, it can be "watch out above" for shareholders.

    So what's the benefit to a 19 P/E stock market? All those high-quality, 10 P/E stocks that have major "catch-upside"!

    Here are some of my favorite long ideas with serious catch-upside.

    Caterpillar

    (CAT) - Get Caterpillar Inc. Report

    At about $75, Caterpillar trades for only 13.5 times this year's earnings and 11.5 times next year's. Investors seriously underappreciate the fact that machinery stocks represent the new, cyclical growth sector. The global infrastructure boom represents a tailwind for Caterpillar's mining, energy and large construction earthmoving equipment. The company's intermediate-term financial goal suggests $9 earnings power over the next few years. If it can deliver, the stock will be well north of par.

    Nabors

    (NBR) - Get Nabors Industries Ltd. Report

    TheStreet Recommends

    At roughly $35, the shares trade for an embarrassingly low 9.8 multiple in a 19 P/E market. This leading driller, often lazily reduced to a North American natural gas sound bite, has excellent commodity and geographical diversification. It serves both oil and gas producers domestically and abroad. A rising domestic rig count should precipitate better investor psychology and a multiple revaluation. A mid-teen P/E ratio gets a double in the shares on 2008 estimates.

    Asyst Technologies

    (ASYT)

    At $6.85, Asyst trades for only 13 times my current fiscal-year estimate, and the company is seriously under-earning. This maker of automation systems for semiconductor and flat-panel-display manufacturers has significant unrealized earnings power as management continues to restructure the business. If the current management team cannot deliver on the expected improvements, perhaps another industrial automation company such as

    Rockwell

    (ROK) - Get Rockwell Automation, Inc. Report

    or

    Emerson

    (EMR) - Get Emerson Electric Co. Report

    can. At 70% of revenue, Asyst is dirt cheap as well.

    Jakks Pacific

    (JAKK) - Get JAKKS Pacific, Inc. Report

    Quite simply, Jakks trades too cheaply compared with other toy companies such as

    Mattel

    (MAT) - Get Mattel, Inc. Report

    and

    Hasbro

    (HAS) - Get Hasbro, Inc. (HAS) Report

    . The third-largest domestic toy company has some warts, including a

    World Wrestling Entertainment

    (WWE) - Get World Wrestling Entertainment, Inc. Class A Report

    lawsuit that might cost some cash and modest earnings.

    However, its 10 P/E and 5 EBITDA multiples more than discount most unfavorable legal outcomes. Otherwise, the company has done an excellent job acquiring small, niche toy businesses and growing them. Expect double-digit revenue and earnings growth this year and a much better valuation level for the shares. A 15 P/E ratio in a 19 P/E market gets the shares 50% higher.

    Apache

    (APA) - Get Apache Corporation Report

    At nearly $78, Apache is also too cheap vs. its peer group. This leading independent producer of oil and gas possesses strong unit volume growth along with strong cash flow metrics. If you haven't looked lately, oil and natural gas prices are running nicely higher than Wall Street's consensus. At 10.7 times earnings and 5.5 times cash flow, the stock has serious catch-upside to its 7-cash-flow-multiple peer group.

    A lot of positive factors continue to affect stock market valuations favorably: low inflation and interest rates, strong corporate profits and free cash flow, huge equity shrinkage from deals and repurchase programs. For these reasons, stocks are generally priced around 18 to 19 times estimated earnings. And yes, that even applies to the S&P 500, despite what the talking heads contend on

    CNBC

    .

    Stay valuation-disciplined if you want to add new money to your stock portfolio. Buying truly cheap shares should offer you the opportunity to participate in a continued rally. Yet should the tide turn for whatever reason, value stocks typically offer more downside protection than the average stock.

    Despite high valuations, share prices may continue to rise. If they do, stocks with catch-upside could provide quite tasty returns.

    Please note that due to factors including low market capitalization and/or insufficient public float, we consider Asyst Technologies to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

    At the time of publication, Marcin was long AIG, Caterpillar, Nabors, Asyst, Jakks Pacific and Apache, although positions may change at any time.

    Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of commentary by Marcin, both before and after it is posted. Under no circumstances does this column represent a recommendation to buy or sell stocks. This column is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback;

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    to send him an email. Marcin is not required to update or held responsible for updating any portion of this column in response to events that may transpire subsequent to its original publication date.