The Stock Market: Expensive or Not?

The attractiveness of the stock market, from the perspective of an individual investor, is largely based upon the determination as to whether or not stocks are "cheaply" valued. Unfortunately however, it can be difficult for the average individual to properly assess current market valuations. First of all, stocks do not adhere to the everyday concept which tells us lower prices are synonymous with cheapness. This misunderstanding has been prominently displayed by many of our acquaintances who have proudly announced the purchase of a stock(usually in a social setting, usually drinking is involved)  based upon the assumption that it is cheap. These folks have made decisions based upon a perceived cheapness, relative to some price anchor that they have established for the stock in question. For example, a stock that traded in the $30 range only two years ago, and is now but a $5 stock, will be purchased on the assumption that it will inevitably return to $30. Secondly, there are numerous valuation metrics from which to choose from, most of which provide seemingly contradictory signals. For instance, a stock might look cheap based upon the ratio of price to as-reported, undiluted earnings, but appear expensive when subjected to a discounted cash flow analysis. Obviously, there is plenty of gray area in all of this.

As far as this current equity market is concerned, we have been told repeatedly that stocks are "in the bargain bin". We will now look to the available data for the S&P500 index and attempt, in an impartial and straighforward manner, to either verify or refute that claim.

Index-wide earnings for the S&P500 are reported in the two separate ways below:
Operating Earnings- Income from the sale of goods and services
As-Reported Earnings- Income from continuing operations as defined by Generally Accepted Accounting Principles (GAAP)

Our earnings figure of choice will be "As-Reported Earnings". This decision stems from a couple of grievances we have with the "Operating Earnings" figure. First of all, we are wary of the fact that these numbers are not standardized according to GAAP. While standardized accounting principles are not perfect, we ardently prefer a slightly flawed yet standardized measure over the inconsistency that is inherent to earnings designations made outside of the GAAP framework. Most suspect, we believe, is the fact that Operating Earnings exclude what is known as "unusual items". Essentially, a company has characterized a particular charge to earnings as "unusual" and thus can pretend that it did not really happen. Unfortunately, the world is defined by events and occurrences that would be largely considered unusual. Unusual things happen, and they matter. That being said, we will still provide the data for both earnings figures if for no other reason than to appease those who suffer from chronic delusions. Below are the quarterly, aggregate earnings per share for the S&P500, as reported by Standard and Poors:

Operating Earnings As Reported Earnings

Q1 2009 $10.07                  $7.57

Q4 2008 -$0.09                   -$23.25

Q3 2008 $15.96                   $9.73

Q2 2008 $17.02                    $12.86

At the time of this writing, the S&P500 index stands at 883.24. Given the current annualized index-wide earnings rate of $40.28(Operating) and $30.28(As Reported), the S&P500 is trading at earnings multiples of 21.92 or 29.16, depending on your method of earnings calculation. Furthermore, since 1988, the index has traded at an average P/E of 19.27 and 23.16 respectively. Typically, the index has overshot its valuation average, to the upside during the final stages of economic expansion, and to the downside during economic contractions, recessions, depressions or whatever your title of choice may be. When assessing this all in the entirety, we must conclude that the S&P500 is currently somewhat expensive. Granted, the market is anticipating a bounce in earnings over the next several quarters. Should this happen, now would be, in hindsight, a great buying opportunity. However, we would strongly caution individual investors against wading into the current market, unless however, you are extremely comfortable and familiar with the use of option contracts as risk management tools. That is but all the wisdom we currently have to offer.

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