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investing strategy

After the stunning rebound in equities this year, investors around the world are asking the same question: Is the stock market cheap, expensive, or just right?

The valuation debate is as old as the market itself, but with the economy struggling to drag itself out of recession even as unemployment remains stubbornly high, it's taken on new urgency for investors trying to determine their next moves. Investment reporter John Heinzl asked four prominent market strategists for their take on the market's valuation. If their answers prove one thing, it's that people examining the same data can come to vastly different conclusions about what the figures mean.

VINCENT DELISLE / Scotia Capital

Despite the 52-per-cent rise in the S&P/TSX composite index from its March lows, Mr. Delisle will tell you categorically that the market is not overvalued. For those who say it is, it's a case of sour grapes.

"People who are raising the red flag about markets being overvalued are those who missed the rally," he says.

How can he be so sure? Well, as dramatic as the rebound was, it was to be expected given that the market went from pricing in a depression to anticipating a modest recovery. Economic indicators are starting to turn higher, and 80 per cent of S&P 500 companies are beating earnings expectations.

The "beat" ratio is "probably the highest we've seen in a decade. Typically a good quarter would be 65 to 70 per cent," he says.

Based on estimated 2010 per share earnings of $80 (U.S.) for the S&P 500 - a level consistent with a modest economic recovery- the index is trading at a forward price-to-earnings multiple of about 13.9. That's below the historical average of 15, suggesting the market is still undervalued, he says.

Some commentators have argued that the profit gains are being driven largely by cost cuts and that, without an upturn in sales, the recovery is doomed to fail. Mr. Delisle isn't buying it: Sales are starting to rise on a sequential basis and, he says, the profit rebound we're witnessing is typical of the late stages of a recession.


MYLES ZYBLOCK / RBC Dominion Securities

When Mr. Zyblock is trying to gauge whether the market is underpriced or overpriced, he looks at the 10-year price-to-earnings multiple. It's similar to the regular P/E, except that the E is the average earnings over the previous 10 years, to smooth out the ups and downs of the business cycle.

Since 1881, the 10-year P/E for U.S. stocks has averaged 16.3. That compares with a reading of 19.7 today, suggesting the market is slightly overvalued. So does that mean buying stocks now is a bad idea? Not necessarily.

Mr. Zyblock is the first to admit that such an elevated P/E tells us almost nothing about where the market is heading in the short term. The 10-year P/E was at a seemingly unsustainable 35 in 1998, for instance, but the market proceeded to soar 55 per cent over the next two years before the tech bubble burst.

The 10-year P/E does, however, tell us something about where stocks will be a decade hence. Generally, inflated P/Es point to small annualized gains or even losses, and low P/Es are associated with the highest returns (see chart).

Based on today's mildly elevated P/E - and assuming average historical returns - an investor who buys now and holds for 10 years can expect an annualized gain, including dividends, ranging from 5.7 per cent to 7.9 per cent.

The take-home message for investors: "If you've got a 10-year horizon, it's not the best time to invest given the observable history. But it's also not nearly the worst time to invest, either," Mr. Zyblock says. The good news for Canadians is that the S&P/TSX is trading at a 10-year P/E of about 16.4, which is only slightly higher than the long-term average of 16.14, based on data going back to 1956.


DAVID ROSENBERG / Gluskin Sheff + Associates

No matter which way you look at it - forward P/E, trailing P/E - the market is vastly overpriced, Mr. Rosenberg says.

"In fact, by some measures, the S&P 500 is already trading at valuation levels that would ordinarily be consistent with an economic expansion that is five years old as opposed to a recovery that, at best, is in its infancy stages," he said in a note to clients.

Consider the trailing 12-month P/E on the S&P 500. At the time Mr. Rosenberg wrote his note last month, the trailing P/E stood at 27.6 on an operating basis - one of the highest readings on record at the end of a recession. Including all the recession-related writedowns companies have taken, the P/E was an astronomical 140.

As for forward earnings estimates, he says they're not to be trusted.

"For nearly four years now, the consensus has been way too optimistic on the one-year earnings outlook 100 per cent of the time. ...," he wrote.

"So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market."


GEORGE VASIC / UBS Securities Canada

Based on next year's earnings estimates, Mr. Vasic believes the market is "fairly valued." UBS analysts are calling for S&P 500 earnings of $81 a share in 2010, "and I believe those expectations will largely be met."

On that basis, the S&P 500 is trading at a forward P/E of about 13.7, less than its long-term average of 14 to 15. As for the S&P/TSX, it's priced at about 13 times next year's estimates, below its average of 14.7 since 1987.

What's more, next year's earnings estimates represent the early stages of the economic cycle, and profits should continue increasing as growth picks up.

"Next year's earnings are not yet mid-cycle, never mind top-of-cycle. We are still climbing back up," he says. "The message is that there's still room to grow in the markets."

This scenario could be derailed, however, if the recovery fails to materialize and the economy slips back into recession, which would make it tough for companies to achieve earnings estimates.

But with all the stimulus being poured into the economy, "I would say the coast is clear, certainly for the next year or so," Mr. Vasic says. While a double-dip recession is possible, he considers it a "lower-probability scenario."