“One of the things that makes this market confusing is that some valuation gauges clearly indicate this market is cheap. James Paulsen, chief investment strategist at Wells Capital Management, recently brought up the "Rule of 20." According to this, the market is fairly valued if its price-to-earnings ratio is equal to 20 less the inflation rate.

Right now, the rule suggests that the market's P/E should be about 17.7 -- or 20 minus the core inflation rate of 2.3%. But the S&P 500's multiple is actually a mere 14.5 times analysts' 2006 earnings estimates and 13 times analysts' 2007 estimates of $95.64.”     -Barron's, 6/12/06

 

One of the issues that seem to be confusing to investors is the difference between “not expensive” or "fairly valued" and “cheap.”  I think its from years of massive overvaluation that has led some observers to think that Not Absurdly Expensive somehow = cheap.

First, let’s start with not expensive:  A P/E of 17 or so is not terribly expensive – especially after the prices paid in the 1990s. That 17 # is the median trailing P/E for the past 50 years (See this chart). I suspect the 17 number may be somewhat skewed by the gogo years in the 1990s.

If you take the data going all the way back to 1871, you end up with a trailing P/E of 11. That data, in turn, may be skewed by the Great Depression.

Either way, however, the present P/E hardly qualifies as “cheap.”  It is at best fair value, which does not exactly make stocks a compelling bargain. Have a look at this chart (via Jeremy Grantham) for a better sense of how cheap P/E is at present:

“Fairly valued” is just the snapshot of where we are; What happens if we look at the moving picture?

“If the P/E expanded to 17.7, the S&P would trade at 1529 on analysts' 2006 estimates or 1693 on their 2007 earnings estimate. Those would be gains of 22% to 35% -- something investors can only dream of after last week's miserable performance.”

Not only are P/E’s not expanding, they are going the opposite direction – we are in a period of cyclical P/E multiple compression. Recall that during the last secular Bull market, P/E expanded from 7 in 1982 to the 30s in 2000. By that measure, this multiple expansion was where 75% of the bull market gains came from.

Now, we are on the other side of the mountain. P/Es are compressing, meaning investors are increasingly less willing to pay for that dollar of earnings. This helps to explain why despite all the share buybacks, dividend increases, double digit year over year earnings gains and M&A activity, stocks have been unable to make much headway.

Cheap? Hardly…

>

 

Source:

The Trader: No Mood for Shopping   
The Dow drops more than 3% on the week -- but cheaper stocks may not be bargains.
JACQUELINE DOHERTY
Barron's 6/12/06
http://online.barrons.com/article/SB114989188597676567.html