Stocks overvalued? Depends on which yardstick you use

One thing has become obvious during the endless debate in recent months about whether stock markets were overvalued: There’s more than one way to look at stock valuation.

The answer to the valuation question differs depending on whether you’re looking at forward 12-month price-to-earnings or trailing 12-month P/E. Or maybe you’re talking about Robert Shiller’s cyclically adjusted P/E (CAPE) measure. Perhaps you prefer price-to-book-value? Or price-to-cash-flow?

But there’s more to the valuation debate than just which measure to choose, argues Oppenheimer & Co. Inc. chief investment strategist Brian Belski. He says investors may need to rethink what is “normal” for stock valuations – as well as what it means to be outside of the norm.

Exploring the CAPE

The CAPE valuation for the S&P 500 – a current darling of analysts, which uses inflation-adjusted, 10-year average earnings per share in order to smooth out anomalies in the earnings cycle – sat at 21 at the start of last week, well above its historical average of 18. That fact has led many market strategists to argue that U.S. stocks were considerably overvalued – leaving the market ripe for a 10- to 15-per-cent correction. One might even argue that this overvaluation lends some fundamental credence to the panic selling the U.S. market saw last week.

But Mr. Belski says this interpretation ignores the historical relationship the S&P 500 has had with CAPE. Typically, the two move along similar paths; when one is above its historical trend, the other is, too. But while the CAPE is above its historical norms, the S&P 500 hasn’t yet recovered to its long-term historical trend line after the 2008-09 plunge. This suggests stock prices have some catching up to do.

“There have only been two times since World War II when CAPE was this far above average with the S&P 500 price levels below average,” he wrote in a report last week. When it happened in 1995, the S&P 500 rose 27 per cent in the following 12 months; when it occurred in 2003, the index gained 16 per cent in the next 12 months.

A new normal

But even looking at good old-fashioned P/E, stocks aren’t overvalued at all if you consider two key influences on stock-market valuations: Inflation and interest rates.

In times when rates and inflation have been higher, P/Es have typically fallen in response. But when rates and inflation are near historical lows – as they are now – higher P/Es are typical. Mr. Belski’s analysis shows that current P/Es look quite reasonable, given inflation and interest-rate levels.

Still not satisfied? Well then, Mr. Belski has devised a “valuation composite,” which combines six equally weighted valuation measures (trailing P/E, forward P/E, price-to-book, price-to-free cash flow, price-to-sales and P/E-to-growth, or PEG). What does it show? That U.S. stock valuations are in line with long-term norms.

World stocks and the euro fall as investors doubt massive plan to contain Europe’s debt crisis

World stocks and the euro fell Tuesday as the massive relief rally triggered by a $1-trillion plan to contain Europe's debt crisis fizzled out.

In Europe, the FTSE 100 index of leading British shares was down 84.80 points, or 1.6 per cent, at 5,302.62 while Germany's DAX fell 79.98 points, or 1.3 per cent, to 5,937.93. The CAC-40 in France was 56.41 points, or 1.5 per cent, lower at 3,663.88.

All three indexes enjoyed one of their best days in months Monday after the European Union unveiled a massive €750-billion financial support package to defend the euro and prevent the debt crisis that started in Greece from spreading to other big debtor countries like Portugal and Spain.

A pullback is expected when Wall Street opens later, too – Dow futures were down 97 points, or 0.9 per cent, to 10,644 while the broader Standard & Poor's 500 futures fell 12.60 points, or 1.1 per cent, to 1,144.

“Yesterday's burst higher is already looking short lived amidst concern over a wide range of issues,” said Ben Potter, research director at IG Markets. “Without doubt when gains of 5 per cent or more are seen in a single day a degree of reversion is perhaps to be expected.”

Though the package has helped ease near-term concerns about a wave of defaults across Europe, concerns about the solvency of the indebted countries remain – whether governments, which are still running sky-high deficits, will be able to push through massive austerity measures for years to come remain.

“Progress has been made, but the whole sovereign debt looks very like a can of worms,” said David Buik, markets analyst at BGC Partners.

Moreover, the European Central Bank's new role in sweeping up government bonds has stoked concerns about its independence from politicians – Axel Weber, president of Germany's central bank and a leading member of the ECB's governing council, appeared cautious about the bank's new responsibility.

Whatever divisions exist within the ECB and whatever pressure may have been put on its President Jean-Claude Trichet to intervene directly in the debt markets, the central bank is on a different course from that being pursued elsewhere – while the ECB is expanding monetary policy, other banks like the U.S. Federal Reserve and the Bank of England are starting to normalize it.

That may explain why the euro has given up most of the gains it garnered from late Friday when the markets were first alerted to the possibility of a bigger than expected EU plan – by late morning, the euro was down 0.8 per cent on the day at $1.2691.

“As the dust settles from yesterday's shock and awe bailout package, the realization that this is a sticking plaster to a much deeper rooted problem has slowly permeated through and the euro has given up most of yesterday's gains,” said Michael Hewson, analyst at CMC Markets.

The other major currency in focus Tuesday is the British pound, amid growing uncertainty about what the next government will look like. The currency has been under pressure ever since the Liberal Democrats said late Monday they were opening discussions with the Labour Party as well as the Conservatives, who won most seats and votes.

By late-morning London time, the pound was 0.3 per cent lower at $1.4814.

So far, bond investors don't appear to be worried – a £2.25-billion 17-year auction went smoothly for the government as the issue was covered nearly two and a half times by bids.

Earlier in Asia, stocks gave up much of their previous day's advance.

Japan's Nikkei 225 stock average fell 1.1 per cent to 10,411.10 while South Korea's Kospi dropped 0.4 per cent and Australia's S&P/ASX 200 shed 1.1 per cent. Benchmarks in mainland China, Taiwan, India, and Singapore also slid, while Hong Kong's Hang Seng index retreated 1.4 per cent to 20,146.51.

Stocks in the Philippines bucked the regional trend, surging 3.9 per cent as Sen. Benigno Aquino III, son of Philippine democracy icon Corazon Aquino, opened up a commanding lead in presidential elections after campaigning on an anti-graft platform.

Oil prices also lost their shine, with benchmark crude for June delivery down $1.03 to $75.77 a barrel in electronic trading on the New York Mercantile Exchange. The contract rose $1.69 to $76.80 per barrel on Monday.