It's Up! It's Down! It's Cheap! It's Expensive!

If you listen to the business news, a myriad of market pundits are shouting,

• "Beware!  The market has gotten ahead of itself!"
• "If you don't get in now, you'll miss this upturn!"
• "The market is getting very expensive here!"
• "The market is historically very cheap!"
• "Buy gold!"

Who's right?

Well, as always, I think the best judge of that is you.  All you need is some information, and you're likely to make a much better decision with your money than anyone who has an agenda.

I.  What do we mean when we say "the market?"

Many of you have heard of the Dow Jones Industrial Average, often called the "Dow."  The Dow is thirty companies (3M, AT&T, Alcoa, American Express, B of A, Boeing, Caterpillar, Chevron, Cisco, Coke, Disney, DuPont, Exxon, GE, HP, Home Depot, IBM, Johnson & Johnson, Kraft, McDonalds, Merck, Microsoft, JP Morgan, Pfizer, P&G, Travelers, United Tech, Verizon and Wal-Mart.)  Since there are about 5000 publicly traded companies, so this is a rather small snapshot.

A much better measurement of the market is the Standard & Poor's 500 (S&P 500), which are 500 large publicly traded stocks, most of which are based in the US.  Let's use this much broader index when we refer to the market.

II.  What is a P/E?

A P/E is a fraction which consists of

• The Price of the index as the numerator, and
• The Earnings for that index as the denominator. 

The S& P 500 index is now trading at 1067.59.  That's the P.  It is projected (by Standard & Poor's) to earn $69.20 next year.  That's the E.  1067.59 divided by 69.20 is 15.42.  The P/E of the market is 15.42.  That means that for every dollar the market earns, you are paying $15.42 when you buy the index at this price.

Last year, the P/E was 28.37.  The market was trading at 1099.23, and it earned $38.74 over the last twelve months.  The market is cheaper than it was last year, but you knew that. 

The real question is what is a "normal" P/E?  The historic long term average for the S&P 500 is 15.82.  So, this index is cheaper than its long term average.

III.  The Market is Ahead of Itself

Let's see if people who say this are right.  At its low last March, the S&P 500 traded at 666.79.  It is now

• Up 60% from its low of 666.79 last March, and
• Down 30% from its high of 1564.74 in October, 2007

It's trading very near a "normal" P/E of 15.82.  People who think the market is ahead of itself think that times are not normal.  We have a huge deficit.  We have high unemployment.  We are coming out of the worst recession since the Great Depression.

These people may be right, except for one thing.  The market is a discounting mechanism.  That means it is priced for events about 6 - 9 months in the future.

Do you think things are getting better?  Do you think we're on the road to economic recovery?  If so, the market may be fairly priced (but not the bargain in was in March).  If not, you probably think it's come too far too fast.  Your opinion is as good as any.

IV.  If you don't get in now, you'll miss this upturn.

If the best reason you can give for doing something now is that prices will go to the moon if you don't, then you're using the same reasoning that people used to buy Internet stocks in the late 1990's and houses in this decade.  It's not a good reason to buy.

V.  Buy gold

Gold is, historically, a TERRIBLE investment.  What it is, however, is a hedge, and insurance policy against disaster.  If currencies lose value (like our dollar has in the recent economic meltdown), people rush to gold as an internationally accepted commodity. 

If you think the US economy is going to hell in a hand basket, buy gold.  Otherwise, it's ridiculously expensive (an all time hight of $1050 per ounce), and is much more likely to go down over the long term than it is to go up.

So, there you have it.  You have all the information you need to be a pundit.  Draw your conclusions based on the facts, and act accordingly.

Is the Stock Market Cheap?

If the answer were "yes" or "no", this would be a short column.
I don't write short columns.
First of all, we have to decide what we mean by "cheap".
I. Ancient History
Going back to the last quarter of 1936, you would have paid an average of $15.82 for every dollar of earnings for the Standard and Poor's 500 Index (more diverse than the better known Dow Jones Industrial Average, which consists of 30, as compared with 500 companies). That average price is the numerator (top number in the fraction) of the Price/Earnings, or P/E ratio. The denominator (bottom number in the fraction) is the amount the S&P 500 earns. So, the average P/E (or amount you pay for every dollar of earnings you're buying) has been 15.82
Last Friday, the S&P 500 average was $1028.93. That's the price. S&P projects the next twelve months' earnings to be $48.67.
1028.93/48.67 = 21.14 Right now, you're paying $21.14 for every dollar the S&P 500 is projected to earn for the next year. That's 25% more than the average price has been since 1936. So, using that measurement, no, the market is not cheap.
II. Last Year
A year ago last Friday, the S&P 500 average was 1282.83. Earnings over the last year were $33.60.
1282.83/33.60 = 38.18. $33.18 is 80% more than $21.14, so the market is a lot cheaper than it was last year. You may have heard something about this. The market is down a lot.
III. Forward vs. Trailing Earnings
Many of you are racing to your Wall St. Journals and saying, "Hey, Kitty, what gives? Their P/E ratio is different from yours!"
You're right.
Some financial publications do the math this way:
Right Now Price divided by Last Year's Earnings
I do my math like this:
Right Now Price divided by NEXT YEAR'S EARNINGS
Why do I do that? Last year's earning were earned by people who bought the market last year. When I talk about earnings, I am talking about now - not last year. I get my earnings projections from Standard & Poor's - not some Wall St. schlub who's trying to talk me into buying or selling. Standard & Poor's doesn't care if I buy or not, so I trust their projections more than I trust those who have a stake in how the answer looks.
My preference.
IV. Comparable Yields
The Federal Reserve, and a lot of other really smart people determine the value of the market by comparing it with what you'd get if you invested someplace else.
Since you're much too smart an investor to jump in and out of the market, paying short term capital gains taxes on all your sales, you are a long term investor. Short term investors don't belong in the stock market. Stock markets can correct, as you've seen recently, and short term investors can get their heads handed to them in corrections.
So, the long term investor compares the price they pay for the market to another long term investment - the 10 year Treasury Note. That's a loan to the US Treasury for that collection of deficits we've been running up lately.
The ten year Treasury Note is paying 3.48%. So, what is the market paying?
It's the reverse of the P/E, it's E/P. Again, the projected earnings are $48.67 and the market is trading at 1028.93.
48.67/1028.93 = 4.73%
4.73% is 26% more than the 3.48% Treasury Note yield, so your return on the stock market looks a lot better than your return on a 10 year bond. And it should.
Those stock market earnings aren't guaranteed. Something bad could happen. There's risk in the market. That's why you should get paid more.
But 26% more is pretty good under anybody's measurement.
V. So, is the market cheap?
Historically cheap? No
Cheap compared to last year? Yes
Cheap compared to comparable yields? Yes
More yes than no.
If this stuff were easy, everybody would be rich.