Are Stocks Cheap?

If you're not in the business of following stock market returns, you might be surprised to learn that the stock market has gone down in price for almost 11 years. Back in the year 2000, the S&P 500, which is the best recognized measure of stock market value, traded at a price of about 1,500 and today trades at a price of about 1,350.

• That's like having an investment account that was worth $150,000 in the year 2000 being worth $135,000 11 years later.

So has this long period of stagnating and declining prices created a situation where the stock market is cheap? You'd think that this should be a pretty easy question to answer. When you shop for other things, like clothing, appliances and food, it's pretty easy to tell if what you're buying is a good bargain. But the world of finance doesn't lend itself to such clear cut answers.

There are lots of people who write about stock market values but one of the most insightful is Professor Robert Shiller of Yale. You may recall that Professor Shiller wrote the popular and prescient book called Irrational Exuberance, where he warned investors that stocks were too expensive at the end of the 1990s. And he's written several other books since then reflecting on the markets and the price of all sorts of financial assets.

Today, Professor Shiller still thinks stocks are a bit expensive, even though the stock market's price hasn't grown in 11 years. He has some rather elaborate models he works with, but he basically takes an average of company earnings for the last 10 years and compares those average earnings to the price of the stock market. This is the P/E (Price to Earnings) ratio you often hear talked about in the financial press. By his calculation, the P/E for the stock market is about 23, whereas the long term average is about 15. Since the current P/E is higher than the long term average, stocks look expensive to him.

But not everyone agrees with Professor Shiller's method. I recently came across another research report from David Bianco, who is the chief US stock strategist for Bank of America. Bianco doesn't like to use the 10 year average earnings method promoted by Shiller. He uses a method that focuses more on the strong earnings growth from the depths of the financial crisis two years ago, and he screens out certain one-time events that he doesn't consider likely to happen again, such as the collapse of bank earnings. Using his method, he comes up with a P/E of about 14.5, which is below the long term average of 15. So to Bianco, stocks look cheap.

Both of these guys are well respected analysts. How can they come up with such different figures since they're both looking at the same market? I mean, who's right? Are stocks cheap or expensive? Well, they're probably both right in some way.

To put Shiller's P/E number in perspective, in the year 2000, he calculated the P/E in the market at 44 (again, the long term average is 15), so the fact that he calculates it at 23 today tells you stocks are about half as expensive as they were 11 years ago.

And the reality is that companies in the S&P 500 produce almost twice the earnings they did 11 years ago and pay out about 55% more in dividends, but trade at a lower price. So clearly stocks are much cheaper than they were a decade ago.

But stocks are not as cheap as they have ever been, which is Shiller's point. There were periods where stocks traded at P/E ratios below 10. So it's certainly possible they could go lower, but that doesn't always happen.

So you have to weigh the fact that you don't know if they'll go lower against the fact that they're trading at about half they value they were a decade ago.

The reality is there's no way to tell if they're cheap. The basic question is do they look like a fair value for the long term, such as over the next 20 to 30 years. While you're not getting the best value ever, you may be getting a reasonable value.

Bottom line. Stocks are cheaper and that should give you more confidence in their potential long term performance.