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AAII Investor Update: Are Stocks Cheap or Expensive?
Thursday, April 21, 2011
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Market Valuation Indicators
Two finance professors explain how market valuation indicators have historically performed.


Model Portfolios
These real-world portfolios have solid performance track records and are a great educational tool for our members.

AAII Model Portfolio March Return 1-Year Return
Mutual Fund 1.0% 18.8%
Shadow Stock 2.4% 35.1%
ETF 0.7% 16.9%



Discussion Boards
AAII members discuss how they use the model portfolios.

Most Popular AAII Articles

  1. “Climbing the Ladder: How to Manage Risk in Your Bond Portfolio”
  2. “Four Fundamental Tests Every Stock Investor Should Use”
  3. “The First Cut: Thomsett's Fundamental Tests”

(As a reminder, the markets will be closed tomorrow, April 22, in observance of Good Friday. To those of you celebrating the religious holidays, I wish you a happy Easter and a happy Passover.)

The S&P 500’s valuation was the source of some debate before the hubbub about the negative watch rating on U.S. sovereign debt took over. While the federal deficit is a problem that needs to be dealt with, stock valuations are more likely to have a shorter-term impact on your portfolio. (This, of course, assumes that Congress raises the debt ceiling. The debt market is currently acting as if Democrats and Republicans will reach some type of agreement.)

The bears have pointed to Yale economics professor Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio. This valuation measure, which is based on the last 10 years of inflation-adjusted earnings, currently calculates the S&P 500’s price-earnings ratio (P/E) to be 23.47. (Shiller calculates the CAPE ratio as of April 8 using estimated inflation data for March and April.)

Mark Hulbert, editor of the Hulbert Financial Digest and a speaker at this year’s AAII Investor Conference, says the ratio is now 43% above its historical average. He further identified four previous periods when the ratio was at similarly high levels and notes that stocks did not fare well afterward. To be fair, Hulbert does note that he was looking at a small sample size and that there have been instances where the CAPE ratio has stayed at high levels before a bear market set in.

The other thing that has the bears roaring is the valuation of the Russell 2000. This small-cap index is trading at a trailing 12-month (TTM) P/E multiple of 27.3 and a forward-looking (earnings over the next four quarters) P/E of 18.8 (as of Wednesday’s close). Not exactly cheap by either measure.

The bulls will counter, however, that large-cap stocks are, in fact, inexpensive. The S&P 500 is trading with a TTM P/E of 15.1 and a forward-looking P/E of 12.9 (as of Wednesday’s close). These numbers stack up against projected profit growth of 15.0% for 2011 and 14.0% for 2012, according to Thomson Reuters data.

Earnings yield (earnings divided by price) also favors the bulls. The S&P 500 has a TTM earnings yield of 6.6%, which compares very favorably against the 3.6% yield for 10-year Treasury bonds. (Proponents of earnings yield suggest buying whichever asset class has the highest yield.)

Determining who is right is a subjective call. Earnings over the last 10 years were adversely impacted by two recessions, including a very severe financial crisis. Profits for the past 12 months may or may not be characteristically representative of what will occur in the future. Projected earnings are dependent on the quality of the forecasts, which are always just educated guesses.

As an investor, you have two choices. One, you can take a side on the valuation argument and hope that you made the right call. Two, you can continue to look for well-managed companies with identifiable growth prospects and reasonable valuations. The first choice carries a 50% chance that you will be wrong. The second choice does have downside risks, but if you hold a diversified portfolio, you will at least narrow your margin for error. It is always easier to build a more conservative stock portfolio than it is to consistently guess when is the right time to jump in and out of the market.

Another Viewpoint of Market Measures

Finance professors Dale Domian and William Reichenstein discussed the historical record of Shiller’s CAPE ratio, as well as two other market valuation indicators, in a January 2009 AAII Journal article. Though the article was written near the bottom of the last bear market, their findings and suggestions for individual investors remain relevant for the current market conditions.

Model Portfolios Updated on AAII.com

The Model Mutual Fund Portfolio and Model ETF Portfolio had another strong month in March, returning 1.0% and 0.7% respectively. In comparison, the S&P 500 was flat and Vanguard Total Stock Market Index fund (VSTMX) edged up 0.4%.

The Model Shadow Stock Portfolio matched the Vanguard Small-Cap Index fund (NAESX), which both gained 2.4%. The DFA US Micro Cap fund (DFSCX), however, outpaced the Shadow Stock Portfolio by rising 3.3%. Although all three portfolios are ahead of their respective indexes for the past 12-month period, each one is trailing its index in the first quarter of 2011.

There were no changes to the Model Portfolios in March. As always, you can see the Model Portfolios and their respective buy and sell rules in the Model Portfolios section of AAII.com.

See how other members are using the model portfolios on the AAII Discussion Boards.

Asset Allocation Survey—What Asset Classes Are You Holding?

Our monthly Asset Allocation Survey tracks how AAII members are allocating their portfolios. If you have not yet taken the survey this month, please do. It’s quick, and the results help us. Plus, once you are done, you can see how other members are allocating their portfolios. Take the survey.

The Week Ahead

Nearly 160 members of the S&P 500 will report earnings next week. Included in this group are several Dow components. 3M (MMM) and Coca-Cola (KO) will report on Tuesday. Boeing (BA) will report on Wednesday. ExxonMobil (XOM) and Proctor & Gamble (PG) will report on Thursday. Caterpillar (CAT), Chevron (CVX) and Merck (MRK) will report on Friday.

The week’s first economic report will be March new home sales, which will be published on Monday. Tuesday will feature the Conference Board’s April consumer confidence survey and the February S&P Case-Shiller home price index. March durable goods orders will be published on Wednesday. Thursday will feature the first estimate of first-quarter GDP and February pending home sales. March personal income and spending data and the final April University of Michigan consumer sentiment survey will be published on Friday.

The Federal Open Market Committee will conduct a two-day meeting starting on Tuesday. Federal Reserve Chairman Ben Bernanke will hold an inaugural quarterly press conference on Wednesday afternoon to present economic projections and provide additional insight into the latest policy statement.

Atlanta Federal Reserve Bank President Dennis Lockhart will speak publicly on Thursday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 32.2%, down 10.1 points
  Neutral: 36.8%, up 10.1 points
  Bearish: 31.0%, unchanged

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


Bullish sentiment plunged 10.1 percentage points to 32.2% in the latest AAII Sentiment Survey. The percentage of investors who expect stock prices to rise over the next six months is at a five-week low. This is also the first time in four weeks that bullish sentiment is below its historical average of 39%.

Neutral sentiment, expectations that stock prices will remain essentially flat over the next six months, soared 10.1 percentage points to 36.8%. This is the highest neutral sentiment has been since March 4, 2010. It is also the first time in five weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, was unchanged at 31.0%. The historical average is 30%.

The sharp increase in neutral sentiment follows modest decline in stock prices and a continued climb in gasoline prices. Though bullish sentiment has been above its historical average for the last three weeks, optimism among individual investors has been cautious. Corporate earnings, a rebounding economy and the stock market’s rally have given individual investors hope, while the sluggish labor market, rising gasoline prices, federal deficit and global events are ongoing sources of concern.

This week’s special question asked AAII members how much impact the political wrangling about the federal deficit ceiling was having on their sentiment toward stocks. Responses varied from no impact to a significant impact. Some AAII members did not view the deficit issue as having an immediate impact, but thought it could adversely affect stock prices in the future if it is not dealt with.

I should point out that the survey period ran from Thursday, April 14, through Wednesday, April 20. The majority of the responses were provided prior to Standard & Poor’s issuing of a negative credit watch warning for U.S. sovereign debt on Monday morning. There was no difference in the variance of responses before or after the warning was announced.

Here is a sampling of the responses:

  • “As the reaction to the downgrade of U.S. debt by S&P showed this week, the political wrangling can have some temporary impact on stock sentiment.”
  • “I think it is significant, but I also believe there are enough grown-ups on both sides of the political aisle to not let the country default.”
  • “It adds a significant amount of uncertainty, which has a significant impact on the outlook for growth.”
  • “No impact on sentiment. The geopolitical events, resource demand versus supply, and worldwide financial risk are having the major effects on sentiment.”
  • “Not much impact yet, but give it a few weeks.”
  • “It is not having any effect on my sentiment, because this is what politicians do. No action and lots of talking.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.