Some investors and analysts are convinced that stocks are cheap, even after the market's gravity-defying gains over the past few months.
Others are warning that stocks have risen too far, too fast and are poised for a pullback any day now.
So whom should we believe? Is the market undervalued, overvalued or - as Goldilocks would say - just right? Let's try to answer this question using one of the most popular valuation measures, the price-to-earnings (P/E) ratio.
George Vasic, strategist at UBS Securities Canada Inc., calculates that the S&P/TSX composite index is trading at 13.5 times estimated earnings over the next 12 months. In other words, for every dollar companies are expected to earn, investors are willing to pay $13.50.
Mr. Vasic then went back over different periods to see how the current P/E measures up. From 2004 to mid-2008, he found that the average forward P/E was 14.5.
Over the past two decades, the average forward P/E was 14.7. Both are slightly higher than the current level, suggesting stocks are reasonably priced.
"Thus, TSX valuations are not inflated, and are better described as having nearly re-normalized over the last two months," he said in a note to clients.
If analyst earnings estimates for 2010 hold - and that's a big "if" given how quickly estimates can change in this environment - a return to the historical average P/E of 14.5 would imply a S&P/TSX of 12,000 by year-end.
That's about 1,899 points, or 18.8 per cent, above yesterday's close of 10,100.95
A LONGER VIEW
So stocks are a buy, right? Not necessarily.
Some analysts look at the market's P/E based on actual earnings over longer periods. This approach smoothes out the profit peaks and valleys created by the business cycle.
Yale University economist Robert Shiller looks at the P/E for the S&P 500 index based on the average inflation-adjusted earnings over the previous 10 years. The idea here is to get a fuller picture than you would get by focusing on just one year's worth of earnings.
Based on 10-year "normalized" earnings, the P/E on the S&P 500 fell to 13 in March - the lowest since 1986. Since then, however, the market has powered ahead, lifting the P/E to about 15.6. That is roughly in line with the 127-year average, suggesting stocks aren't expensive or cheap, but somewhere in the middle.
If you want to see screaming bargains, you have to go back to 1982, when the normalized P/E plunged to 8 - roughly half the current level. The 10-year P/E also dipped below 10 in 1974, 1942, 1932 and 1921.
In other words, there is no rule that says stocks won't become cheaper from current levels - possibly a lot cheaper.
"If long-term valuations revert back to the low P/E ratios reached at the end of the last secular bear market in the early 1980s ... that means the S&P could, conceivably, fall another 50 per cent in value from here," said Sharon Daniels, president of Weiss Capital Management in Palm Beach Gardens, Fla.
"Don't get me wrong. I'm not predicting stocks will fall that much during this secular bear market ... but it is a possibility. After all, it has happened several times before."
WHAT TO DO?
As always, keep a diversified portfolio of stocks, fixed-income securities and other assets. And don't forget cash. You'll need it if the market becomes ridiculously and unequivocally cheap again.
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