Stocks: Buy on the cheap? Not so fast

Any market drop brings calls to bargain hunt. But numbers suggest stocks need to fall further in order to move higher.

By Shawn Tully, Fortune editor-at-large

NEW YORK (Fortune) -- For smart investors, the market's dire indicators Monday morning, following on the heels of Wall Street's worst week in four years, should provide a reminder of what the bulls want us to forget: That stocks historically go through extremely rough periods, and that those perilous interludes usually follow strong markets that push prices to the limit.

So the questions investors should be asking themselves are basic: What are the chances of a big, long-lasting downward move in stocks? And are the returns I'm destined to receive at current prices high enough to compensate for the chances of a wrenching revaluation?

The answers are cause for alarm - even without last week's drop, investors should be plenty scared.

But before we get to those answers, it's important to remind yourself of what is, or should be, glaringly obvious: From day-to-day, week-to-week, and month-to-month, stock prices are almost totally unpredictable. They wax and wane with rumors, fads, speculative fervor, cockeyed optimism, over-wrought pessimism, and all manner of what economists call "noise" that's unrelated to what really matters, their fundamental earning power.

No one can make a credible near-term prediction. But by weighing the numbers, we can assess, then handicap, the long-term outlook.

The key figure, what distinguished Dartmouth economist Kenneth French calls "the holy grail of investing," is the "risk premium." It's the extra return that stocks offer over what investors would pocket in risk-free investments, chiefly government bonds.

When the risk premium is high, investors generally get a fat cushion against future bumps. They receive a big extra return to compensate for the risk of owning stocks instead of Treasuries. But when the risk premium is extremely low, investors are on shaky ground and may begin to question whether they're getting paid enough for the nail-biting unpredictability of owning stocks.

It's precisely when the risk premium is extremely low that the danger is greatest for a severe correction in stock prices.

So where is the risk premium right now, and what does it augur for the future?

First, let's calculate the return you can expect from a portfolio of stocks at current prices. The best guide is the earnings yield, or the inverse of the P/E multiple. The higher the earnings yield, the better the future return. The reason is simple: With the same earnings growth, you make a lot more money when prices are low, versus earnings, than when they're inflated. You're simply getting more corn flakes in the box.

Right now, the P/E on the S&P 500 stands at around 18. But that figure is misleading. Profits are now at a cyclical peak, making valuations appear artificially low, since profits generally decline after hitting such lofty levels.

So it's best to smooth out those profits by using a formula that takes a 10-year average for earnings, adjusted for inflation. That puts the current P/E at around 25. Hence, the earnings yield is 4 percent. Profits rise with inflation as companies hike prices for everything from cars to computer chips. So to get the expected future return, add today's inflation rate of around 2.5 percent to the 4 percent earnings yield. Hence, the best bet is that you'll receive around 6.5 percent on your stock portfolio.

The risk premium is the difference between that 6.5 percent and what you earn on a safe investment such as Treasury bonds. The rate on the 10-year Treasury is currently 4.6 percent. So the risk premium stands at around 2 percent.

The rub: That figure is way below the historical average. Over the past 50 years, investors have demanded a spread over Treasuries of around 5 percent in exchange for the perils of owning stocks. So today's investors are getting a puny margin compared to those who bought in, say, in the early 1980s, when risk premiums went into the double-digits - followed, by the way, by spectacular returns.

The danger is that investors will decide that they need to get paid a lot more for the rough ride involved with owning equities. So what happens if the risk premium goes back to 5 percent? To get there, stock prices would have to drop by around 40 percent.

But before you gasp, let me reassure you: It's by no means certain that will happen. Stocks aren't necessarily overpriced. A logical, rational explanation could underlie today's tiny risk premium. It's possible that investors no longer view stocks as highly risky. A combination of enlightened monetary policy that makes recessions less frequent, and low transactions costs thanks to discount brokers and 401(k)s, may mean that investors are willing to accept lower returns going forward than in the past.

If that's the case, the risk premium could remain at around 2 percent. That would leave multiples at around 25. But remember, if the risk premium is low, so is the return you'll get from stocks.

Contrary to Wall Street's rosy view, you can't have both very high prices and big future returns. So if the risk premium stays where it is now, investors can expect returns we already calculated, around 6.5 percent. That's not great, but it's still a bit better than Treasuries.

So what's the most likely outcome? Will the risk premium stay where it is now, and hand investors low, steady returns? Or will prices fall sharply, raising the cushion back to the historic 5 percent, and enabling investors who rush to buy at the new, low prices to once again pocket double-digit gains?

The answer is that no one knows for sure. Even in retirement, Alan Greenspan keeps talking about the dangers of low risk premiums - though the press barely mentions his warnings.

But we do know one thing for sure. In the past, when P/Es have soared, they always returned to their historic average of around 14 to 15. So-called mean reversion isn't a law, but it has a powerful history.

So if your main goal is protecting your nest egg, short-term Treasuries are looking mighty good right now. If you relish stocks, the low-P/E, high-dividend variety, including big banks like Bank of America (Charts) and Citigroup (Charts), are a lot more attractive than the Googles or Yahoos.

In short, you need a strong stomach right now to bet heavily in equities, especially tech. As for the argument that stocks are no longer highly risky, maybe it's true. Or maybe not.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.