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The Great Debate: Are Stocks Pricey?

Eequities have soared more than 70% since last March, but they’re still down 25% from their 2007 peak. Does that mean stocks are trading at a bargain, or has the recent rally made the market frothy again? Well, that’s at the center of a raging debate on Wall Street.

In one corner you have Yale economist Robert Shiller, who popularized a method of calculating the market’s price/earnings ratio—the most common gauge of valuing stocks — using 10 years of historical, inflation-adjusted earnings. Using this system, Shiller famously predicted the bursting of the tech bubble in the late 1990s.

Today the Shiller P/E says the market is less than half as expensive as it was back then. But at 21, this trusted gauge is signaling that stocks are again overvalued—by as much as 30% — after last year’s stunning rise. And if history is any guide, this means there’s a decent chance equities will deliver subpar annual gains of less than 4%, after inflation, over the next decade (see the chart at right).

But is the Shiller P/E the right measure for this economy? Jeremy Siegel, a Wharton professor and perma-bull economist, says no. In fact, the author of Stocks for the Long Run has publicly argued that the Shiller P/E isn’t appropriate when the economy is pivoting from recession to growth — as it is today. After all, even if 2010 earnings exceed expectations, that one year will be swamped by several years of unique profit setbacks.

Coming out of a recession, it’s better to calculate P/Es using projected earnings over the next 12 months, Siegel has argued. And based on 2010 forecasts, Siegel thinks stocks could be selling at around a 20% discount to the historical norm — a bullish sign.

Many market pros agree there’s a drawback to Shiller’s P/E today. S&P’s Sam Stovall likens it to “a supertanker making a turn—it’s not going to tell you what you need to know about what is happening now.”

But siding with Siegel and projected profits means “you’re taking one set of predictions to make another prediction,” says York University finance professor Dale Domian.

Fortunately, there’s a compromise. Domian and Baylor finance professor William Reichenstein rely on the same 10 years of historical earnings Shiller does, which is their nod to the past. But rather than averaging the entire period, they pick out the highest peaks to calculate a P/E. Their assumption—which is a nod to the future—is that corporate profits will at least get back to their prior-cycle highs. This method says that equities are fairly priced and could see annual gains of slightly more than 6%, after inflation, over the next decade.

Is that a better guess than one using Shiller’s P/E? It depends on how fast earnings grow, as the chart shows. Yet there are ways to position your portfolio to reflect a frothy market (in case the Shiller P/E is right) while capturing additional opportunities for growth (in case it’s wrong).

HEDGING YOUR BETS

► Dividend payers. If profits rebound rapidly, both the share price and payouts of dividend-issuing stocks should see a boost. But if there’s a speed bump, dividend stocks — which sport a lower P/E than the broad market — are apt to suffer less, in part because of the cushion the dividends provide. For example, SPDR S&P Dividend ETF (TICKER: SDY) lost 23% in 2008, compared with the S&P’s 37% drop. An easy way to bet on this group is Vanguard Dividend Growth (VDIGX). which seeks stocks likely to keep boosting payouts.

► “GARP” funds. Funds that employ what’s known as the growth-at-a-reasonable-price approach, or GARP, invest in fast-growing firms, which would benefit if earnings start to sizzle. But these funds expressly look for shares selling at lower-than-average P/Es, which would offer some protection in an overpriced market. Selected American Shares (SLASX) focuses on firms with above-average earnings growth that have been temporarily beaten down, such as the drug giant Merck.

Seeking a compromise between good value and growth is probably the right move for this uncertain market—whether you’re managing a mutual fund or your own 401(k). ■