Are valuations too high?

A look at adjusted price-to-earnings data suggests the answer is yes.

By Motley Fool Pick of the Day Feb 4, 2011 1:01PM

Image: Arrow Up (© Photodisc/SuperStock)A standard way of judging the market's valuation is by looking at historical price-to-earnings data. You can also go a little deeper by using the cyclically adjusted price-to-earnings ratio, or the CAPE. As you'll read below, the Fool's Matt Koppenheffer has CAPE fear.

 

Rex Moore, Motley Fool Top Stocks editor

 

For long-term investors, pondering the question "Will the market go up?" is a guilty pleasure, like gorging on In-N-Out double-doubles. And yet we still do it. OK, maybe you don't, but I do (both, actually).

 

A key component to this question is whether stocks are overvalued, undervalued, or reasonably valued. If the answer is "undervalued," we can feel pretty good about being buyers, while if they're reasonably valued selective stock-picking can usually uncover some bargains.

 

But if stocks are overvalued, that's a problem. Finding worthwhile investments becomes more difficult and there's a greater chance that the entire market will sink.

 

So what's the story right now?

 

This time it's ... different?
Investing life would be a lot easier if it were a snap to figure out whether the market is over- or undervalued. But alas, it's not.

 

In support of the "undervalued" thesis, we can look at the fact that high-quality franchises like Chevron (CVX) and JPMorgan Chase (JPM) are trading at less than 10 times forward earnings. To be sure, there are questions over how long the price of oil will stay up and just how healthy the financial sector really is, but those are still eye-catchingly low valuations.

 

At the same time, the price-to-earnings ratio on the S&P 500 is 16.7, which is below the average of 22.5 during the period between 1988 and today.

 

But what keeps bugging me is the fact that the CAPE -- that is, the cyclically adjusted price-to-earnings ratio, which is a valuation measure that uses average earnings over a 10-year period -- is well above its historical average. The bull in me would like to respond to that by saying that valuations in the late 1800s -- which is where the data begins -- aren't useful in 2011. But I think a simple picture tells us all we really need to know. 

 

                            Source: Irrationalexuberance.com.

 

This chart tells a pretty clear story: Stock valuations as measured by the CAPE have, over time, revolved pretty consistently around the long-term average. That suggests that the massive deviation that took place in the 1990s and the first decade of this millennium is still adjusting and will likely lead to a period of lower valuations. To suggest otherwise would be to utter the classic "It's different this time" -- a phrase that never fails to make me uneasy.

 

And the moral of this story? Investors should be particularly conscious of valuations and wary of getting too complacent. Putting an exact timeline on when valuations will adjust downward is a difficult (if not impossible) proposition, but I am not fond of betting against mean reversions like this.

 

Fool contributor Matt Koppenheffer owns shares of Chevron, but does not own shares of any of the other companies mentioned. Chevron is a Motley Fool Income Investor selection. The Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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