Are stocks still cheap?

One market guru's answer might surprise you

By John Reese Apr 16, 2010 5:09PM

How expensive (or cheap) are stocks right now?

 

That's the question that scores of strategists and pundits have been trying to answer lately, and they are coming to a variety of different conclusions. That's not surprising; valuing the broader market is, in fact, always tricky because of the array of methods you can use. Even within the often used price/earnings ratio there are a number of possibilities -- do you use trailing 12-month earnings? Projected earnings? Five- or ten-year average earnings?

But one perspective I found particularly intriguing came this week from Jeremy Siegel, the Wharton professor and Stocks for the Long Run author. In an interview with Knowledge@ Wharton, Siegel said investors need to take into account that we're coming out of a deep recession when they value the market. Right now, he said, stocks are selling for about 15.5 times projected 2010 operating earnings -- about the historical average. But coming out of recessions, Siegel says, the average market P/E for the next full year has historically been about 18.5. "That’s why I still think there is room for stocks to run up,” he says.

 

Siegel's not the only guru I follow who believes that -- though there are certainly others who disagree.

 

For example, top fund manager Ken Heebner and bond guru Bill Gross offered pretty different takes on where stocks are headed in a CNBC interview this week. Heebner says he thinks the economy is in the beginning of several years of expansion. Consumers are spending again, and he expects an “earnings explosion” that will make stock valuations look much more attractive than they are now.

 

Gross, however, says he sees slower-than-usual gross domestic product and earnings growth ahead for the U.S. And that means a world in which stocks return 5% to 6% per year.

 

David Dreman, whose writings form the basis of one of my Guru Strategies, sounded more upbeat this week in an interview with GuruFocus.com. Ever the contrarian, Dreman said he's looking at two areas that aren't very popular right now: stocks and real estate. “Everything people are cowering away from today I would prefer to invest in,” he said. “If we have an inflationary environment, value stocks should do well over the next 4-5 years. And … real estate has been hit so hard if you have a holding period of 5 years with 20-25% leverage, it is a 4-1 play on the upside.”

 

Dreman says he thinks that once the unemployment rate comes down below 6%, we’ll see major inflation rates of 10% to 12%. While that may take several years, he indicates it’s time to buy up inflation-beating assets now. His “number one choice would be stocks,” he says, saying that historically stocks have proven to be the best inflation-beaters.

 

Newsletter writer and money manager John Mauldin, meanwhile, says he sees a 50% chance the U.S. will dip back into recession in 2011. Two big reasons: high unemployment and big coming tax hikes. He told Bloomberg that means a 40% plunge could hit the stock market, and that investors should treat the current market as a trader’s market.           

 

Liz Ann Sonders of Charles Schwab, who called both the start of the recession and the turnaround that appears to have begun last year, is "relatively optimistic" that stocks will continue to climb, however. In her latest market commentary, written with Schwab’s Brad Sorensen, Sonders says earnings will likely drive the market over the next few weeks. But she and Sorensen stress that investors should take a longer-term perspective. “Although pullbacks will undoubtedly occur, especially now that investor sentiment (a contrarian indicator) has become more optimistic, we believe they will be relatively brief,” they write. “Investors remain somewhat skeptical about both the stock-market rally and the sustainability of the economic recovery, leading to investor sentiment correcting relatively quickly with any pullback and setting the stage for a renewed move higher.”

 

John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

 

 

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