Are stocks cheaper than ever?

Low rates make stocks look even more attractive, but can it last?

By Motley Fool Pick of the Day Feb 27, 2012 3:46PM

Image: Woman reading newspaper in livingroom © Tetra images/Getty ImagesBy Dan Caplinger

 

Even as the stock market has hit multiyear highs recently, stocks still look cheap by many standards. Yet many investors are staying on the sidelines, fearing an imminent end to the three-year-old bull bounce after the market meltdown of 2008 and early 2009. That leaves one key question: Is keeping cash available a smart move or a waste of capital?

 

The bull argument
A recent article from Bloomberg said that the S&P 500 is almost as cheap as it ever has been compared to bond yields. When you take the S&P 500's earnings and divide it by the current level of the index, you get what's known as an earnings yield. Right now, that yield is 7.1%, and the spread over current 10-year Treasuries is more than 5 percentage points -- its lowest level since the market's bottom in March 2009.

 

More encouraging for stocks is the fact that companies appear to be starting to funnel more of their cash into capital investment. Having spent years bolstering their balance sheets after finding themselves cash-poor at critical moments during the financial crisis, many companies are finally loosening the purse strings. Now, capital investment is growing at its fastest pace since before the financial crisis. And assuming that the returns on that investment can exceed the 2% or so that Treasuries are earning right now, the benefits should fall through to corporate bottom lines.

 

Some warning signs
Of course, for every argument, there's a counterargument. One of the biggest, many believe, is that rates in the bond market are artificially low. The Federal Reserve owns more than $1.5 trillion in Treasury notes and bonds on its balance sheet, as well as more than $840 billion more in mortgage-backed securities. That demand is serving to keep rates lower, discouraging saving both among consumers and businesses. When the Fed finally acts to shrink its balance sheet, then rates should naturally rise.

 

Moreover, on the other hand, earnings have gotten a huge boost in recent years from improvements in productivity and profit margins. Yet with high levels of unemployment, pressure on companies to boost their payrolls could force them to reverse that trend, sacrificing productivity for job gains. That in turn could halt recent earnings growth, pushing earnings yields lower.

 

Great margins of safety
If you're looking to get money back into the market, cheap valuations for the overall market shouldn't persuade you just to buy an index fund. If you're diligent, you can find even better earnings yields even among blue chip stocks.

 

For instance, energy companies are priced as though $100 oil will be a fleeting phenomenon. Both Chevron (CVX) and ConocoPhillips (COP) carry earnings yields of 12% or better at current levels. Moreover, with Conoco planning to split off its refining division from its core exploration and production business, shares may have a catalyst to advance in the near future -- even if energy prices hit a plateau.

 

Technology companies are also presenting some attractive values. Corning (GLW), for instance, has one of the hottest products in its Gorilla Glass, which many mobile-device makers rely on for durable screens. Yet the stock gives shareholders an earnings yield of 13% right now, pretty much discounting any prospects for future growth.

 

Finally, automakers look cheap. Despite the obvious challenges of a struggling Europe and a slow recovery in the U.S., both Ford (F) and General Motors (GM) have seen recent strength. In particular, with GM having gone through bankruptcy, it's arguably in the best financial condition in years -- yet investors are still treating it with the same kid gloves they did before its massive restructuring.

 

Be smart
Stocks may look cheaper than ever by some metrics, but that doesn't mean that you can afford to buy just any stock. By looking for even better bargains, you can give yourself a margin of safety that could help prevent big losses in case the current bull run comes to an abrupt end.

 

Fool contributor Dan Caplinger rarely looks a gift horse in the mouth. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Corning and Ford. Motley Fool newsletter services have recommended buying shares of Corning, Chevron, General Motors, and Ford, as well as creating a synthetic long position in Ford. 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 is of the finest quality.

6Comments
Feb 27, 2012 5:52PM
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The melt down and the continuing recovery doesn't mean the economy is healthy, it is just feeling better.  Housing market will not truly recover until employment and incomes adjust upward.  And to accomplish that will require investment in America's infrastructure and manufacturing sectors, with a kick in the pants of stingy bankers.  Main Street needs some vitamins in the way of fiscal policy, which means Congress is going to have to quit the lolly gagging for the musical chairs and get a JOBS bill passed while they are trimming the budget of wasteful spending.
Feb 27, 2012 7:28PM
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They are "cheaper" because they are worth less.  People know that the Fed is manipulating the market by secretly buying eqyuities, either directly or indirectly, so people are not buying stocks.  Stock indices are rising on low volume, a sign of lack of confidence in the manufactured "rally".  When the Fed drops out, the bottom will fall out.  

The "big boys" (called the "smart money") are cautiously playing along, investing enough to look like it is participating, but holding onto cash.

Feb 27, 2012 5:08PM
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Cheap money to buy cheap stocks.  Sounds too good to be true.  Sounds like a Bernie Madoff plan.  Smile
Feb 27, 2012 10:20PM
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Exactly by which standards do equities look cheap? The author fails to explain his statement that equities are cheap at all. Does anyone remember what happened to equity holders when GM went bankrupt?
Feb 27, 2012 10:27PM
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Open-mouthed Are stocks cheaper now? Well it depends how deep and wide your wallet is. For me the  18,000 I owe on my car is a lot of money but to some celebrity they could buy rolls royce and ferraris half dozen  at a time but it is so cheap for them. It's all relative. Facking stupid but lucky idiots.Smile.
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