As I pointed out in my last Money and Markets column, I believe U.S. stocks are fairly valued given the state of the economy. But after almost tripling since March 2009, the S&P 500 Index is no longer cheap.
A potential red flag is the fact that three-quarters of the 25% gain in the benchmark index this year has been driven by an expansion in the price-to-earnings ratio (P/E) rather than growth in earnings per share.
That can't go on indefinitely. At some point, profit growth will have to justify higher stock values.
And that brings up a critically important rule-of-thumb for investors: Current valuation makes a big difference in future returns.
There are different ways to measure valuation, the most popular being the P/E ratio. But there are different methods for calculating it, which can yield different results.
There is the so-called forward P/E ratio, which divides current stock prices by expected future earnings, typically over the next 12 months. The problem is that earnings estimates are notoriously inaccurate (usually overly inflated) especially at key turning points in the economic cycle.
So what looks like an attractive forward P/E today can be off the mark in a few months or a year.
Then there is the trailing P/E ratio, which divides current stock prices by earnings in the previous 12 months. Again, there is a wide difference of opinion on what form of earnings should be used in this calculation.
In addition, you can use "reported" earnings, which include some expense items that may or may not repeat in future and can distort the P/E. Or you can use "operating" earnings excluding one-time charges (and other "bad stuff"), but this measure can make stocks look more profitable than they really are.
An alternative P/E measure was proposed by Warren Buffett's mentor, Benjamin Graham, decades ago. To help smooth out the ups and downs of the business cycle, Graham suggested that you divide stock prices by the past five years' average earnings, creating a more stable, long-term yardstick for valuation.
For the most part, Graham used it to measure the valuation of individual stocks, not the market as a whole. The measure was later popularized by Yale economist and recent Noble Prize winner Robert Shiller in his book "Irrational Exuberance."
Shiller refers to the approach as CAPE (cyclically adjusted price-earnings) and applies it to the S&P 500 Index. Shiller simply divides the S&P 500 price by the average of the past 10 years' earnings, after adjusting both for inflation.
* At the peak of the dot-com bubble in 2000, this measure warned investors that market valuation was indeed irrational, as the CAPE reached 44 times earnings.
* And just before the housing bubble burst, which triggered another bear market, CAPE nearly reached 30.
* Today, the S&P 500 is valued at just over 24 times earnings, according to the CAPE measure, as shown in the graph above.
That's nearly 50 percent above the average CAPE valuation of 19 for U.S. stocks based on data back to 1950, according to Shiller.
Shiller himself admits that U.S. stocks are "high priced" today, but he doesn't consider valuation excessive and certainly not in a bubble. But here's the rest of the story.
As I mentioned above, current market valuation has a direct influence on the returns you're likely to receive from stocks over the next several years.
The higher today's value, the lower your expected future gains.
According to Shiller's analysis of the historical record, when the market has a CAPE of 24, as it has today, stocks tend to return just 2.5 percent per year on average (after inflation) over the next 10 years.
Let me give you some perspective on what that means in terms of dollars and cents.
Since the post-crash low in March 2009, the S&P 500 has climbed from 666 to around 1,800 today. That's a gain of 170 percent in terms of price appreciation. (Dividends add even more.)
But if the CAPE measure is correct in predicting 2.5 percent annual gains over the next decade, expect the S&P 500 to reach just 2,300 by 2023, up only 500 points, or 28 percent from where it is today.
It's likely the benchmark index will be higher than that in nominal terms, because future inflation will push stocks higher, but it illustrates my point that valuation matters.
And when it comes to making new investments, it's critically important to identify markets that are most attractively valued today, in order to reap the biggest gains tomorrow (or 10 years from now).
That's why I'm convinced the best upside potential over the next several years is likely to come from stock markets outside the S&P 500.
Mind you, I'm not saying it's time to abandon U.S. stocks altogether; the S&P 500 is likely to keep chugging higher, but I believe other stock markets will perform even better.
The graph above is from a recent Fidelity report that caught my attention. The methodology used is similar to Shiller's CAPE but measures five years of earnings instead of 10.
Also, it's applied to a wide range of global stock markets outside the U.S.
You'll notice that U.S. stocks (red box) on this scale also appear highly priced. In fact, most major developed markets have a rich valuation today, except for a few European stock markets.
On the other hand, the vast majority of emerging markets offer compelling value today.
Crunching the numbers, I find similar results. Emerging stock markets look especially attractive today.
In fact, many have CAPE ratios far below U.S. stocks, including all of the BRIC stock markets: Brazil and Russia are in the mid-single digits, while China's CAPE is just over 10 — less than half as expensive as the S&P 500 Index.
Emerging markets are a great starting point for further research. The CAPE is just one tool to help you gauge a market's value relative to others, but you'll want to do your own homework and consider other factors before investing.
There is plenty of upside in emerging markets today. They simply aren't as overpriced or as overbought as U.S. stocks, and that's where I'll be looking for new profit opportunities in 2014.
P.S. Throughout this week, my Money and Markets colleagues and I will take to the Money and Markets blog to ask a "Question of the Day" in preparation for our special year-end online conference.
Knowing what you're concerned about and the opportunities you're most excited about will go a long way towards helping us make sure we cover the areas that will help you most.
Today, we're looking for your thoughts on the following topic:
Is Washington LYING to us about economic growth, inflation and employment?
If so, how will these lies impact investors in the year ahead?
Participating is easy: Just click this link to go to the blog, then scroll down and use the handy comment area to join the discussion
Attention editors and publishers! Money and Markets teaser content may be republished with a link to the full story on MoneyandMarkets.com. Such republication must include attribution with a link to the MoneyandMarkets home page as follows: "Source: http://www.moneyandmarkets.com"
Money and Markets: A Division of Weiss Research, Inc. | 15430 Endeavour Dr. | Jupiter, FL 33478 | 1-800-291-8545