As markets have broken through their November lows, it is time to ponder over the eternal question for the stock market investor: are stocks cheap? Certainly, based on almost any valuation parameter available, stocks are much cheaper then they have been at any point in the past two decades. But does this mean that now is a good time to buy?
One of the best ways to value stocks is to look at their price compared to cyclically adjusted earnings. Benjamin Graham proposed to use a 10 year rolling average of Earnings to iron out the business cycle. If we use this 10 year rolling average as the best approximation of cyclically adjusted earnings, the Price/Earnings ratio is spot on its historical average when the S&P500 hits somewhere between 750 and 800. So now that the S&P is under 700, we might conclude that stocks are slightly cheaper then they have been on average over the past 100 years.
But let's look at the past 10 years' Earnings a bit closer. I would contend that the past 10 years were part of one gigantic supercycle that started in 1982 and was charged by an ever expanding credit machine and supported by rapidly growing emerging economies and cheap labor after communism was effectively replaced by hard core capitalism is China, Russia and Eastern Europe. Benjamin Graham's idea to look at a 10 year rolling average of earnings to flatten out the business cycle may not work so well today for the simple reason that we have had only boom, no bust, over the past decade. The 10 year rolling average overestimates future earnings for this reason.
Furthermore, what also bothers me about the past many years are the dividends and the historically low pay-out ratio at on average 30% of earnings. One might wonder how much of the reported earnings were real earnings. Based on their dividend, yield stocks are still more expensive than they have been on average for the last 100 years. And to make matters worse: dividends are falling.
I conclude that that stocks are likely still somewhat more expensive than they have been for the past 100 years. They may look cheap, as they have fallen so dramatically and are now at 1996 levels. But that is simply because stocks have never been more expensive then in the late 1990s. Wasn't it 1996 when Alan Greenspan uttered the words "irrational exuberance"?
But even if I am wrong, and stocks are cheap today, then it is still not time to buy. When looking at valuations over long periods of 100 years and more, it is clear that equities tend to go through long periods of overvaluation followed by long periods of undervaluation. After having turned cheap in 1974 for the first time in 15 years, stocks remained cheap until 1987. Buying equities in 1974 was not a good idea, even though valuations were attractive. It is likely that we are now headed for a long period of undervaluation as well. From that sense the question whether stocks have finally become cheap or not ultimately doesn't matter. What matters is understanding that it is much too early to to start buying.