Are Stocks Attractive Now? Part II
People love sales. Finding a bargain at a store can bring on feelings of utter bliss. The lower the price, the better.
When stock prices go down, however, people get scared. A stock market decline brings fear. It confirms all the bad news that is floating around. People are more apt to want to buy stocks when prices rise. An appreciating stock market brings on a feeling that all is right with the world and the good times will continue.
Stocks should be viewed more like consumer items -- some prices are more attractive than others. The key issue becomes, of course, trying to determine what is a good price.
How do prices look today? Viewing the stock market as a whole, the evidence is mixed. Clearly stocks are less valuable now after the recent run-up than they were at lower levels earlier in the year.
J.P. Morgan Asset Management believes that the best way to look at the relative value of the stock market is to determine how much you are paying for the future earnings of the underlying businesses. After all, investing in a stock is nothing more than buying a share of the future earnings stream that the business will generate.
Based upon projections of the future earnings of the companies in the S&P 500, the stock market is priced today at around 12.4 times earnings. This "price" for the market is at the historically low end. Over the last 18 years, the average price was 16.6 times earnings.
Of course, some people feel that earnings can be manipulated by companies, so there are other metrics, such as price-to-sales and price-to-cash flow. Even using these factors, J.P. Morgan Asset Management has found stocks to be relatively cheap on a historical basis.
There are other valuation methods that make stocks appear less attractive. The Yale economist Robert Shiller takes the 10 year inflation-adjusted average of earnings to smooth out the volatility that prices and earnings can exhibit. Shiller's approach indicates that stocks are priced at over 21 times earnings. Shiller has shown that when stocks are this expensive, they tend not to perform well in the near future.
J.P. Morgan Asset Management counters that Shiller is looking at past earnings whereas what is really important is what companies will earn in the future. Of course, as I mentioned in a previous article, the precarious nature of the world economy makes such predictions quite difficult. Shiller's approach has the advantage of not having to estimate the future.
We end up in a bit of a conundrum. Stocks look somewhat undervalued if the consensus projections as to future earnings hold true. Yet the fragile economy takes away some of the comfort that such predictions will come to fruition.
While investing in stocks has always held some level of uncertainty, it is not, as a learned colleague of mine has said, entirely a crap-shoot. My friend goes on to say that when you are investing in stocks you are participating in the ownership of real operating businesses -- the question becomes separating out price from value. The value of a company's underlying business may not have deteriorated as much as its price.
There are no sure things. There is only a record of the growth of the world economy and stocks over time punctuated by painful periods when that is not the case.
Words of Wisdom
It will fluctuate.
-- J.P. Morgan, when asked what the stock market will do.