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Are Stocks Too Rich?

Even if the market looks dear, stick to your planned allocation or find a seasoned manager who can adjust it for you.

John Coumarianos, 01/29/2010

Ben Graham, in his classic book The Intelligent Investor, argued that most long-term investors should maintain balanced portfolios--that is, portfolios divided roughly evenly between stocks and bonds--at nearly all times. According to Graham, only at unusual moments, when stock prices seem completely dislocated from underlying value, should "enterprising" investors (those willing to spend a significant amount of time and effort studying their investments and valuation) move to either 25% stocks or 75% stocks, depending on prices relative to underlying valuation.

This essentially amounts to tactical asset allocation based on broad market valuation levels. Very few investors have the skill to time such tactical moves well, so we generally discourage investors from such tactics (and so did Graham, though he allowed for it in some cases). In this piece, I'll argue that most investors should stick with their prearranged allocations, despite a seemingly rich market, or pick funds that aren't afraid to hold cash.

Are Stocks Cheap or Dear?
In 2008 and 2009, investors experienced gut-wrenching declines and breathtaking surges in stock prices. Stocks are still not back to where they were at the start of 2008, but in the meantime, earnings have declined and dividends have been cut. So where are we now, at the beginning of 2010, with regard to price and value? Is there a compelling argument for the enterprising investor to deviate from a standard, balanced allocation?

First, it's instructive to look at economist Robert Shiller's website, which gives a historical glance at a cyclically adjusted price/earnings, or CAPE, ratio of the S&P 500 Index. (The concept of looking at this metric comes from Graham himself, and Grantham, Mayo, Van Otterloo analyst James Montier calls it the "Graham & Dodd P/E" in his book Value Investing: Tools and Techniques for Intelligent Investment.) Currently, the ratio is at nearly 21 times, which seems somewhat high by historical standards, though perhaps not inordinately so, given very low interest rates. The current multiple isn't nearly as high as the roughly 45 times earnings multiple the market reached in early 2000 or the 35x earnings multiple it reached in 1929, but it doesn't exactly appear to be a bargain basement multiple either. The average multiple for the index since 1881 is 18 times, according to Montier.

It's also interesting to note that the CAPE never reached the lows in early March 2009 that it did during the Great Depression or even in 1981, when CAPE fell into the single digits. CAPE got to around 13 times in early 2009, but a combination of price increases and earnings declines has driven it up to around 21 times now.

Additionally, Charlie Dreifus of Royce Special Equity RYSEX, who won Morningstar's Domestic-Stock Manager of the Year Award in 2008, noted that the market didn't produce as many "net-nets" in March 2009 (the most recent market bottom) as it did in previous downturns. (A "net-net" is a term Graham used to describe a stock selling at less than two thirds the value of its current assets minus or net of all liabilities--in other words, a really dirt-cheap stock, at least on a liquidation basis.) None of this is to say that Dreifus himself is particularly bearish, but he has an especially keen historical perspective on the markets and on moments when stocks have met certain Graham tests, including the famous net-net test. This is also not to say that the market must get cheaper from here, but as painful as 2008 and early 2009 were, that period certainly could have been worse--which also means buying opportunities could have been greater.

Another possible cause for tempered expectations is Morningstar's own Market Valuation Graph, which shows the market to be 5% overpriced currently. That's not an egregious overpricing and certainly not as high as the all-time high of 14%, but it doesn't appear particularly cheap either. If we dig a little deeper into Morningstar's equity analysis, we see that only 35 stocks currently trade in 5-star territory or far enough below the analysts' fair value estimates to offer the margin of safety warranting a buy recommendation.

Finally, Warren Buffett's famous op-ed piece in the New York Times titled "Buy American. I Am." was published on Oct. 16, 2008, when the S&P 500 closed at 946. It's now at around 1,100 -- 16% higher.

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