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Take your stock valuations with a grain of salt

There has been no shortage of explanations from market seers – some more plausible than others – for the recent resurgence in global stock prices. The list includes everything from good earnings news (go, Google!) to better than expected U.S. economic data and unusual faith that the politicians will somehow manage to resolve the European debt crisis without leaving a trail of shattered banks and broken economies in its wake (apart from Greece, which the markets have already written off).

The bullish types have long insisted such a rebound was inevitable because equities have been priced for the darkest of double-dip recessions, turning equity markets into a bargain-hunter's paradise. Any hint of more positive news, and it would be like Boxing Day at the local big-box electronics emporium.

The people who handle other people's money seem to agree. Developed market equity funds last week scored their first net gains in investor capital flows in more than a month. And in its latest quarterly survey, Russell Investments found that 79 per cent of U.S. money managers reject the double-dip notion, while 57 per cent think the market is undervalued, up sharply from only 26 per cent as recently as June. Another 32 per cent regard stocks as fairly valued.

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That there is so much confusion about valuation, which has become one of the most hotly debated subjects in the investing world, is not surprising. By one gauge comparing stock prices to earnings, U.S. equities are underpriced by more than a third. By another, they are overpriced by as much as a quarter. It's enough to leave any investor with a big headache and little clue about whether stocks truly are too expensive, screaming buys or just about where they ought to be under current conditions.

"Even just a quick scan of the headlines would leave investors torn between sharply divergent opinions on equity valuations," Scotia Capital economists Derek Holt and Karen Cordes Woods comment in a new report. Their own assessment: Equities "are cheap only if one confines one's market memory to the period of the 1990s onward."

The confusion spreads to institutional investors, who seek to discern earnings and stock price trends not merely now or next year but several years down the road. For that they rely heavily on certain longer-term valuation tools such as the Shiller price-to-earnings ratio and Tobin's Q ratio. Both signal that U.S. stocks are still a bit pricey by historical standards. But their flaws may outweigh their value.

"Using something like the Shiller P/E as an argument to say stocks are really expensive moves the proper focus from earnings, where it should be, to valuation, which is a less important place to focus attention," argues Peter Perkins, a partner and global strategist with MRB Partners, who has investigated the worth of the long-term gauges.

The widely tracked Shiller formula, developed by noted U.S. economist Robert Shiller, divides the S&P 500 by the average inflation-adjusted corporate earnings from the previous 10-year period. "It attempts to normalize earnings so people aren't using last year's earnings or 12-month forward earnings to guide stock market valuations," Mr. Perkins says.

By relying on a 10-year moving average, the Shiller ratio eliminates the peaks and valleys, ostensibly giving longer-term investors a truer picture of what may lie ahead. But by its very design, the Shiller approach "tends to overstate the expensiveness of the market," Mr. Perkins says.

Tobin's Q ratio, developed by James Tobin, another prominent U.S. economist, essentially takes the total market value of equities and divides it by the net worth of the non-financial corporate sector, based on the replacement cost of the assets. Historically, the Q ratio has averaged about 0.7. Today, it stands at 0.84, well above the 0.4 range it reached during the worst bear markets of the past 100 years.

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"While we believe both the Shiller P/E and Tobin's Q ratio indicate stocks are fairly valued by historical standards, the … track record bodes poorly for the prospective performance of stocks purchased at such levels," Mr. Perkins warns in a report. "The latest Shiller P/E ratio reading of 18.1 (compared with levels as low as 8 in the worst of times) has historically been associated with a 10-year compound real stock price gain of 4.2 per cent, with a maximum of 12 per cent and a minimum of -7.8 per cent. Based on history, the odds of investors losing money in equities (in real terms) over the next decade are approximately 33 per cent."

MRB's own approach factors in inflation, interest rates and other economic drivers of market performance, as well as the increasing exposure of S&P 500 companies to foreign markets – accounting for about 32 per cent of total profits – which reduces the impact of domestic U.S. conditions.

"It's really earnings that are the principal issue for the stock market," says Mr. Perkins, who leans slightly to the bearish side of the fence. "I would say stocks are at real risk only if earnings are at real risk. If earnings fall apart because we have a big economic downturn that is very deep or lasts for a prolonged period of time, then we will have a very bad performance for equities. But it would not be because stocks are expensive. It would be because earnings had deteriorated a lot."

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