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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.

What Does the Evidence Mean for Investors?
After sifting through all of this evidence, it appears that the market isn't cheap. In the last edition of The Intelligent Investor, when CAPE was a bit over 17 times, Graham argued against increasing stock exposure, saying, "It is hard for us to see how such a strong confidence can be justified at the levels existing in early 1972." Clearly, he'd say the same thing today at 21 times. In fact, in his other book Security Analysis, he remarked that buying stocks over 20 times average earnings was speculating more than investing, because that meant you were willing to accept an "earnings yield" of less than 5% on a risky asset.

But I also think Graham would counsel against most investors radically reducing stocks in a prearranged allocation. Investors tend to time their allocation shifts poorly, doing themselves much harm along the way. That's largely because they make such moves based on emotion rather than hard facts. For example, many investors abandoned stocks at the depth of the crisis in 2008, missing the big comeback in 2009. Our statistics on Investor Returns are grim. They prove that most investors do an awful job of timing the market, consistently selling low and buying high.

So it's worth asking yourself, if you reduce your stock exposure now, will you increase it if CAPE decreases, or will you be terrified at the market decline that caused CAPE to decrease at that point?

It's true that CAPE can decline from the happy result of earnings (the denominator in the P/E fraction) increasing rather than prices (the nominator in the fraction) declining, but it's worth thinking about how you'd react to the latter scenario. If you think your emotions could get the best of you, it's better to stick with your long-term asset-allocation plans.

Besides staying put, a second option is to own a stock fund run by a veteran manager who is experienced at raising cash when he or she thinks prices are too high. For example, Dreifus at Royce Special Equity currently has 18% of the fund in cash. Another possibility is the Wintergreen Fund WGRNX run by David Winters, who, besides putting up solid relative results for his tenure on this fund, managed the Mutual Series funds successfully for six years. Wintergreen currently has more than 13% of its assets in cash, and Winters isn't afraid to hold significantly more when he thinks prices are too high. Finally, FPA Crescent FPACX, run by Steve Romick, is currently holding a whopping 40% of its portfolio in cash and another 25% in bonds. (Keep in mind, though, that Romick's cash position is slightly inflated by some short positions that he typically keeps.) If you choose to go with one or a combination of these funds, the price you'll pay for some downside protection is lagging a roaring market or one taken over by growth stocks.

John Coumarianos is a mutual fund analyst with Morningstar.

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