The great debate: Are stocks pricey?

By Carla Fried, Money Magazine contributing writer


(Money Magazine) -- Equities have soared more than 70% since last March, but they're still down 25% from their 2007 peak. Does that mean stocks are trading at a bargain, or has the recent rally made the market frothy again?

Well, that's at the center of a raging debate on Wall Street.

In one corner you have Yale economist Robert Shiller, who popularized a method of calculating the market's price/earnings ratio -- the most common gauge of valuing stocks -- using 10 years of historical, inflation-adjusted earnings.

Using this system, Shiller famously predicted the bursting of the tech bubble in the late 1990s.

Today the Shiller P/E says the market is less than half as expensive as it was back then. But at 21, this trusted gauge is signaling that stocks are again overvalued -- by as much as 30% -- after last year's stunning rise. And if history is any guide, this means there's a decent chance equities will deliver subpar annual gains of less than 4%, after inflation, over the next decade.

But is the Shiller P/E the right measure for this economy? Jeremy Siegel, a Wharton professor and perma-bull economist, says no.

In fact, the author of "Stocks for the Long Run" has publicly argued that the Shiller P/E isn't appropriate when the economy is pivoting from recession to growth -- as it is today. After all, even if 2010 earnings exceed expectations, that one year will be swamped by several years of unique profit setbacks.

Coming out of a recession, it's better to calculate P/Es using projected earnings over the next 12 months, Siegel has argued. And based on 2010 forecasts, Siegel thinks stocks could be selling at around a 20% discount to the historical norm -- a bullish sign.

Many market pros agree there's a drawback to Shiller's P/E today. S&P's Sam Stovall likens it to "a supertanker making a turn -- it's not going to tell you what you need to know about what is happening now."

But siding with Siegel and projected profits means "you're taking one set of predictions to make another prediction," says York University finance professor Dale Domian.

Fortunately, there's a compromise. Domian and Baylor finance professor William Reichenstein rely on the same 10 years of historical earnings Shiller does, which is their nod to the past. But rather than averaging the entire period, they pick out the highest peaks to calculate a P/E.

Their assumption -- which is a nod to the future -- is that corporate profits will at least get back to their prior-cycle highs. This method says that equities are fairly priced and could see annual gains of slightly more than 6%, after inflation, over the next decade.

Is that a better guess than one using Shiller's P/E? It depends on how fast earnings grow. Yet there are ways to position your portfolio to reflect a frothy market (in case the Shiller P/E is right) while capturing additional opportunities for growth (in case it's wrong). To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.36%4.24%
15 yr fixed3.39%3.26%
5/1 ARM3.36%3.27%
30 yr refi4.34%4.22%
15 yr refi3.38%3.24%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 16,420.80 12.26 0.07%
Nasdaq 4,098.42 2.90 0.07%
S&P 500 1,866.07 1.22 0.07%
Treasuries 2.70 -0.02 -0.70%
Data as of 9:40am ET
Company Price Change % Change
Western Union Co 15.25 -0.80 -4.98%
Regions Financial Co... 10.22 -0.12 -1.16%
Twenty-First Century... 32.52 0.24 0.74%
Oracle Corp 40.08 -0.05 -0.12%
Merck & Co Inc 56.47 0.21 0.37%
Data as of Apr 17

Sections

On eve of hearing UAW says it will no longer challenge loss in organizing election at Volkswagen's only U.S. plant. More

Obamacare sign ups hit 8 million, though final enrollment remains to be seen. More

Schwinn, Trek and Cannondale are all iconic American bicycle brands. But none of them are made in the United States. More

Getting people to donate money is a big business, and some universities, hospitals and other nonprofits are rewarding their top fundraisers with as much as $1 million to bring in the big bucks. More

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.