Commentary > Sivy on Stocks
Are stocks overpriced?
As the bull market approaches its first anniversary, the debate heats up.
February 24, 2004: 6:32 PM EST
By Michael Sivy, CNN/Money contributing columnist

NEW YORK (CNN/Money) - Stocks hit bottom in October 2002, and then bumped along sideways until last March, when the bull market began in earnest. Since then, the S&P 500 has risen almost 45 percent.

Now a debate has broken out over market valuation: Are stocks fairly valued -- or even slightly undervalued -- and likely to continue their winning streak? Or are they ahead of themselves and subject to a sudden setback within the next few months?

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Analysts are sharply divided. Those expecting a correction point out that the average price/earnings ratio for the S&P 500 is currently over 20, versus a historical average of only 16.

This disparity suggests a possible temporary dip of as much as 20 percent.

Analysts who are more optimistic point out that today's low inflation justifies P/Es that are well above the historical average. They also point to various valuation formulas that consider factors such as inflation, long-term interest rates, corporate profits growth and P/Es.

Their conclusion: The S&P 500 is undervalued by at least 10 percent.

Model performance

Much of the debate has centered around a particular formula knows as the Fed Model, because some economists believe it mimics calculations that Federal Reserve chairman Alan Greenspan relies on to assess the health of stock market.

This valuation model compares the relative attractiveness of stock returns to the safe predictable yields available on 10-year Treasury notes. Currently, those yields are so low that stocks look attractive even if share prices are higher than the historical norm.

There are a variety of rebuttals to the Fed Model, including a thoughtful argument made by columnist Mark Hulbert in a recent issue of the New York Times. Hulbert argues that the same economic conditions that lead to low interest rates also tend to reduce corporate profit growth. The result is that the benefits of low rates are largely offset by slower growth (I'm oversimplifying, but that's the gist).

I've known Hulbert for a long time, and I admire his work. But I don't agree with his analysis on this subject.

When you consider an earnings discount model, the impact of lower rates is enormous. That's because future earnings are worth a lot more today when rates are low. And since such models reflect growth over long stretches of time, the benefit of low rates vastly outweighs whatever reduction in earnings growth may occur in the near term.

More important...

But there's something much more important at issue. The Fed Model is totally dependent on the level of bond yield at a particular moment. And even a very small change would massively alter the calculation.

It may be true that the S&P 500 is undervalued by 10 percent today. But if 10-year Treasury yields rise more than half a percentage point over the next six months, stocks might appear equally overpriced.

No serious long-term investor can profit from worrying about transient disparities that are so easily reversed.

To a large extent, the stock market is efficient. And in my view, the only indicators that provide any worthwhile guidance are price/earnings ratios based on long-term historical trends for stock and industry groups, and core growth rates. Moreover, it may take as long as five years for a stock that appears undervalued, based on such long-term benchmarks, to realize its true worth.

That's precisely why I advocate a strategy based on owning a diverse mix of stocks with core earnings growth and dividend yields that offer above-average long-term total return potential. You can see key statistics on 70 such stocks by going to the Sivy Seventy table (click here).

If you consider the stocks' P/Es and their value ratios (a measure that compares P/Es to total return potential, based on projected earnings growth and current dividend yields), you can identify stocks on the list that look cheap at present. Add those bargains to your portfolio, as long as they increase your degree of diversification.

I don't know whether the broad market is going to suffer a 10 percent to 20 percent correction in the coming quarter -- and frankly, nobody else knows that either. There's no point, however, in worrying about things you can't predict.

So concentrate on what you can control: Buy individual stocks, which will minimize your investing fees and expenses; eliminate diversifiable risk; don't buy junk and don't overpay. Get those things right, and plan on holding for a long time.

Odds are, you'll end up doing really well.

Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Tuesday and Thursday of Sivy on Stocks.  Top of page

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