Given the Dow’s bull run during the fall 2012/winter 2013 from roughly 12,500 to 14,340, the concern is warranted – a reservation that’s also supported by the S&P 500 P/E ratio compared to its historical average. What does that comparison indicate?
By that measure, the U.S. stock market is overvalued. On Thursday, the S&P 500 P/E was 23.8, compared to its mean of 16.46 and median of 15.87.
Shiller PE Ratio: Historical Gauge
The P/E ratio cited above is based on average inflation-adjusted earnings from the previous 10 years: It’s the Shiller PE Ratio, or PE10, as compiled by Yale University Economics Professor Robert Shiller.
Further, because Shiller’s metric factors in earnings from the previous 10 years, it is less affected by abnormal swings in any one year.
The highest P/E was 44.2, in 1999, during the Nasdaq/dot-com mania period of the “Roaring '90s” bull market.
The lowest P/E was 4.78 or roughly 4.8 in 1920 -- prior to the start of the “Roaring '20s” bull market. From a P/E standpoint, the Roaring '20s commenced in 1924, with the P/E rising to 9.7 by the start of 1925, then to 11.3 (1926), 13.2 (1927), 18.8 (1928), and a gaudy 27.1 (1929) - the year of the “Black Tuesday” stock market crash.
What’s more, it would take the stock market, as measured by the Dow Jones Industrial Average (DJIA), 25 years, or until 1954 to return to its pre-1929 crash level.
Other points: Periods of rising P/E ratios accompany the 1950s and 1980s economic expansions, and the 1990s “Roaring '90s” expansion.
Equally significant, P/Es over 20 represent overvaluation, they typically don’t last as long -- but they can last many years.
With the above as a backdrop, what’s the prudent stance for U.S. investors given a Dow above-median Shiller P/E levels and uncertainty regarding the U.S. budget and Italy’s government?
Two Words To The Wise
First, two cautions:
1) If you can’t tolerate the risk of a 20 percent pull-back in a stock or group of stocks, you probably should not be invested in stocks, as even under normal financial and economic conditions, stocks can quickly decline 10 percent; amid these conditions, a 20 percent decline is not unusual.
2) If you can tolerate the risk associated with owning stocks, dollar-cost-average with quality companies. In other words, look for companies with demonstrated business models in established markets and buy in stages.
Underscoring: The key is having the ability to wait out market corrections (pull-backs) and ignore short-term, large stock-market drops. This is not a stock market for rookies or squeamish investors.
Here are a few blue-chip companies:
Caterpillar (NYSE: CAT), recent price: $89.53, P/E: 10.6.
CAT Comment: The slowdown in emerging markets represents a pause in revenue growth for this major supplier of earth-moving and mining equipment. But when GDP growth strengthens in these economies, so will CAT’s revenue.
Deere (NYSE: DE), recent price: $89.86, P/E: 11.3
DE Comment: The world’s largest manufacturer of farm equipment and a leading maker of construction machinery will benefit from the need for increased food production and the globally-strong farming/agriculture market.
Boeing (NYSE: BA), recent price: $81.02, P/E: 15.4
BA Comment: The 787 Dreamliner’s lithium-ion battery fire problem has soured some institutional investors on Boeing’s shares, but just view that as a buying opportunity for the world’s largest and best manufacturer of commercial jets. Leisure travel is "in" and will remain in for a long time.
United Technologies (NYSE: UTX), recent price: $91.65, P/E: 17
UTX Comment: This diversified industrial giant has a bright future: It’s a leading manufacturer of air conditioning and heating systems, escalators, and jet engines – all of which are in demand in emerging markets.
Coca-Cola (NYSE: KO), recent price: $39.10, P/E: 19.7
KO Comment: The maker of the world’s most famous carbonated drink has diversified adroitly into other drinks/juices. Further, there’s reason a Wall Street adage goes, “No one ever went broke holding Coke.”
IBM (NYSE: IBM), recent price: $209.33, P/E: 14.3
IBM Comment: Revenue growth will be modest in 2013 for IBM, but strategic growth projects, including the cloud and business analytics, bode well for IBM, longer term.
AT&T (NYSE: T), recent price: $36.46, P/E: 30.2
AT&T Comment: Like other “landline” phone service companies, AT&T is counting on cell phone service revenue growth to more than offset landline voice pressure. Fortunately, that will occur – and with the company adding spectrum, the future remains promising for the old Ma Bell.
CVS Caremark (NYSE: CVS), recent price, $52.15, P/E 17.2
CVS Comment: Almost all macroeconomic and demographic factors are in CVS’s favor: an aging U.S. population, increased use of generic drugs and a dominant position in most major U.S. markets means CVS's shares are headed north.
Procter & Gamble (NYSE: PG), recent price: $76.96, P/E: 19.8
PG Comment: Key premium brands will face pressure in the years ahead, but new products, a solid distribution network and better sales in new markets will offset the above.
Ford (NYSE: F), recent price, $12.90, P/E: 9.
F Comment: Simply, a restructured Ford has survived the Great Recession. Pent-up demand for new vehicles in the U.S., room for market share gains in key emerging markets and a strong performance bringing new models to market bode well for Ford. And how often does one get a chance to buy a vehicle manufacturer with a P/E of 9?
The above are well-capitalized companies with demonstrated business models in established markets, although many, of course, have extensive operations in new markets/emerging markets. Further, the important point is that these companies know how to operate in their respective sectors – not a mean feat or minor accomplishment in these economic conditions.
Choose five of the above, salt them away for 10 years, and at the end of that span, you probably will be glad you did.
Disclosure: Joseph Lazzaro has no positions in stocks but does own U.S. Treasuries, municipal bonds and real estate.