Why Stocks Still Aren’t Cheap

February 20, 2009,
Why Stocks Still Aren’t Cheap
By David Leonhardt

At long last, are stocks cheap? Amazingly enough, they still are not, at least by one commonly used measure.

Stocks fell again today. The Standard & Poor’s 500-stock index closed at 770, which isn’t too far from the low of 752 that it reached in November. In inflation-adjusted terms, the index is about 55 percent below its 2000 peak.

Those comparisons certainly make it sound as if stocks are incredibly cheap. But they aren’t, at least not according to the price-earnings ratio. That ratio, a standard measure of market valuation, divides the average price of stock in the index by the earnings of the companies in the index.

Based on the average earnings of companies over the past year, the current p-e ratio is about 30, far above the long-term historical average of 16. By this metric, stocks actually look expensive and may seem as if they still much further to fall.

The problem with this metric, however, is that it’s overly sensitive to economic swings. Corporate earnings are plunging now, because of the recession. P-E ratios always spike during recessions — and corporate earnings always recover, so many investors simply ignore short-term ratios during recessions.

It makes more sense to look at earnings over a longer period of time, which smooths out the economic cycle. I have written before about a P-E ratio based on the previous 10 years of earnings, a measure favored by Robert Shiller, the author of “Irrational Exuberance,” and others. (I first wrote about it in the summer of 2007, when being bearish was a lot lonelier.)

By this measure, the P-E ratio of the S.&P. 500 is now about 14.5. It’s below average, but not enormously so. By comparison, this ratio fell to 6 during the 1930s and 7 during the early 1980s. In short, stocks are a little less expensive than their historical average. But they are far more expensive than they were at the worst points of the other two worst recessions of the past century.

How could this be? The main answer is that stocks were incredibly expensive before the current crisis began — more expensive than at almost any other point in the last 100 years, save the bubbles of the 1920s and 1990s. They had a long way to fall. The fact that earnings are falling — and may well remain low for the next several years — doesn’t help either.

For the average investor, I would repeat the advice I offered in November:
Stocks are definitely becoming cheaper. If you are a long-term investor, they may even be worth buying at this point. But they may still have a ways to fall.
As per usual, thanks to Howard Silverblatt at S.&P., for providing valuable data.

http://economix.blogs.nytimes.com/2009/02/20/why-stocks-still-arent-cheap/