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Stocks Are Still Not Cheap


In a vacuum, relative to historical perspective, stocks seem a bit on the fully valued side...

A little while back, I wrote what turned out to be a somewhat controversial article. My point then and still is that the average stock in the S&P 500, as opposed to the overall, capitalization-weighted index, was not cheap relative to the median stock back in the Value Line Composite at the 'bubble peak' of March 2000.

A few friends and colleagues correctly pointed out that the analysis was a little of the 'apples versus oranges' approach. Indeed, I had compared the median stock in 2000 (the one in the middle) versus the average stock in 2007 (the arithmetic average of all 500 stocks), and I must agree that the analysis was slightly flawed. I believe that the analysis was correct from a big picture perspective but I wanted to provide an update and a slightly different approach to why I still feel that stocks are overvalued, particularly relative to bonds explicitly backed by Uncle Sam. I intend to show that not only are stocks overvalued from an absolute standpoint as compared to 2000, but also from an asset allocation perspective (the potential forward return of stocks versus risk-free instruments).

First, let's examine at what level the average stock sells for after last week's correction in all major indices in the U.S. I was out of town much of the week on a thoroughly enjoyable trip to New York City with my daughter to watch the Mets play at Shea Stadium and the Yankees (my boyhood favorite team) play at Yankee Stadium. While away, as always, I was watching my Bloomberg and Blackberry during the week as well as keeping up with what the media was saying about the market during the week. Mind you, while I was happy to see the Yanks win in extra innings on Friday night (as Toddo likes to say, 'bad seasons define good fans'), I was sad to hear the same refrain all week that 'stocks are cheap and are a buying opportunity.'

This leads me to the following analysis. For the moment, let's forget about the fact that bond yields exploded higher last week (more on that later). Instead, courtesy of Bloomberg LP, let's focus on what the average stock in the S&P 500 traded for at week's end, after the little correction.

As you can see (focus on the green line),the average stock in the index still trades at 23.72 times earnings, 4.62 times earnings and a dividend yield of 1.56%. In a vacuum, relative to historical perspective, this seems a bit on the fully valued side to me. In case you are skeptical of my analysis, I decided to take a look at a couple of other indices to be sure I wasn't seeing things and to be sure that I wasn't skewing the data to make it look the way I wanted, or in Wall Street parlance, 'talk my position' which is cautious but of course not bearish as I always respect the action of the tape.

So below, please see the same type of analysis for the Citigroup Barra Growth Index (a composite of the largest growth companies in America).

Even here, please note the average P/E of 24.25 times earnings, an average price to book of 5.74 times and 1.10% dividend yield. Nope, no value (at least in my admittedly miserly book) here either.

Again, in a vacuum, stocks seem expensive to me on an historical basis. But let's take a step back to be fair to those saying that the market is cheap and there's a buying opportunity. I am very aware of how the market appears when using a capitalization based approach where the largest companies in terms of size (size does matter to them I guess?) get the largest weighting. Many of these companies are either in the oil and gas patch or in financial institutions like banks and brokers or in 'quasi-financials' like General Electric (GE), whose earnings are derived much from General Electric Credit Corp.

From an asset allocation standpoint, however, the picture changes, in my truly humble opinion. When allocation assets between the asset classes of stocks, bonds and cash, we must compare how stocks look relative to yields. After all, if yields rise, a few very important dynamics develop. First, rising bond yields become more competitive for stocks generally, let alone those with paltry 1.5% yields. Second, rising yields put pressure on operating margins, particularly those of those companies that are dependent on low yields like banks. Third, higher yields tend to produce lower price/earnings ratios if history is any guide.

Along these lines, below please find a logarithmic chart going back 25 years of the yield of the 10 year Treasury note. Note that for now, that trend line has been broken. I have been anticipating this break and have been positioned accordingly in the front end of the yield curve in the safest of instruments like Treasury Bills and short to intermediate term Ginnie Mae's.

I humbly admit that this trend could reverse at any time, but wanted to point it out nonetheless. If stocks are deemed cheap by those that ignore rates, they are only a bit more expensive looking in a period of rapidly rising rates. Note that this does not mean that stocks cannot go higher; it just puts the odds of such an advance as less probable over a long period of time.

Just to be sure that rising rates wasn't an isolated event; I decided to check with my friends at Ned Davis Research to see what yields were doing globally. Lo and behold, the rate rise is not contained to just the U.S.-indeed, rates are headed higher around the globe. See the chart below. A coordinated move in rates worldwide seems to be underway. Answers as to WHY they are rising are not hard to come by. Some claim it is due to growth in emerging and developing nations and some blame it on the amount of leverage that exists in the global financial system. I would simply say that no matter what the reason, they are rising. The reason why rates are rising, in my book, isn't more important to me than the simple fact that they are. So I must monitor this trend closely and continuously to get a good handle on what the 'right' level is for equities in general.

What about other kinds of risk instruments like corporate bonds, utility stocks, REIT's and emerging market bonds? They seem expensive to me as well as shown in the charts on the next page...

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