Are stocks cheap now?
This question is probably dominating millions of investing Americans’ thoughts these days in various forms — is now the time to get back into the [stock] market?  Did I miss out on the rally?  Is the rally going to continue?

Unlike many commentators out there, I honestly cannot answer these questions.  I will however, take a stab at the broader questions and discuss the issues and potential avenues for investment today.  I will also discuss where I think things are going (speculative), but one should avoid making investment decisions on future predictions.  Hopefully, that will help you come to your own conclusions.

At right is a chart from Doug Short at dshort.com who recently took his own stab at this question.  Doug takes a common route for analyzing the overall value in the stock market — a look at stock price to earnings (P/E) ratio based on 10-year average earnings (P/E10).  The P/E10, a method developed by value investing founding father Benjamin Graham, is meant to remove distortions of P/E ratios caused in severe downturns such as the current one wherein earnings decline far faster than stock price.  The graph shows that we are roughly near the long-term cyclical P/E10 average of the S&P 500 index at a valuation near 16.

Historical trends suggest that the S&P 500 will continue down to the single-digit P/E10 realm before fully recovering.  I have one rule about history and stock prices — markets misbehave.  So while the market is likely to eventually continue down to the single-digit P/E10 realm, it may not happen.  Even if it does happen, the time frame cannot be predicted with certainty — it could be this year, two years, or ten years.  Notice from the graph that the last time we were near the median on a downtrend was in the mid-1970’s approximately coinciding with another severe downturn, yet the market did not hit its lows in terms of P/E10 until nearly ten years later.  Someone waiting for the cyclical P/E bottom may be waiting for quite a while and miss out on plenty of earnings growth and dividends.

Over the next year, I think the markets will be heading lower (speculation alert!).  The run-up is largely untenable, and historically, bear market lows are usually retested.  As previously mentioned, markets do misbehave and the market — despite all logic and reasonable assessments of valuations — could continue higher for the next 1 month or 10 years.  The situation at first glance seems hopeless.  Here is the key to breaking through this impasse:

There is Always Value

While the broader market may not look attractive, individual stocks may still be excellent investments.  The longer the investment timeline, the more attractive stocks will look at current valuations.  Staying in line with Benjamin Graham’s own recommendations, an “enterprising investor” should look for the following characteristics in a stock:

1. Current assets at least 1.5 times greater than current liabilities.
2. Long-term debt no more than 110% of net current assets.
3. No earnings deficit in the last five years.
4. Currently pays a dividend.
5. Multiple of current P/E ratio times current price/book ratio is no greater than 22.5 (for simplicity, I will call this a PEB ratio).

Using these criteria, there are currently dozens of stocks that are undervalued relative to their long-term earnings potential.  Using my own slightly modified version of these methods (I will discuss this in detail in future posts), a few great opportunities (only a few examples of many) present themselves:

1. EnCana Corp (ticker: ECA) the large Canadian natural gas affair with a PEB of 7.55 and current dividend yield of 3.49%.
2. Steris Corp (ticker: STE) a medical appliance and equipment company with a PEB of 7.96 and current dividend yield of 1.77%.
3. Snap-On Inc (ticker: SNA) is a tool company with a PEB of 9.93 and current dividend yield of 4.47%.
4. Pfizer Inc (ticker: PFE) the drug giant with a PEB of 19.08 and current dividend yield of 4.48%.

As one can see above, there are a lot of great companies that can be bought cheaply even after the recent rally if one is willing to hold them for a long investment timeline (a minimum of one year, but preferably 5-20 years or more).  While these stocks may retreat to even lower prices in the next year or so, they are still very cheap and will likely produce great returns in the future.

Please note that the above stocks are merely examples – they are not “official” valueseeker stock picks since I have not done a thorough business and financial statement analysis of these companies. I would recommend further research before an investment decision is made, and I may do an official look at these companies in the next few weeks.

What if there really is no value to be found in the stock market or one is not yet convinced that current stock valuations are favorable?  Then forget about the stock market.  There are a dozen or so other markets in which one can invest, surely one must be cheap if stocks are not.  The most apparent and common alternative to the stock market is the bond market.  So is the bond market a safer investment?

An article in the July 13th issue of Forbes by Bernard Condon entitled “The Case for Bonds,” examined this same question.  Condon argues that because stocks are at their historical average, the better investment decision is in bonds.  Specifically, investment-grade corporate bonds and junk bonds are priced below their historical averages despite a recent rally in bonds.

Most individual investors do not have sufficiently large portfolios to properly diversify in individual corporate bonds, though I will discuss individual bonds in the future.  Instead, I suggest investors wishing to buy bonds through a no load, low fee bond fund such as RidgeWorth Total Return Bond Fund (ticker: SAMFX) as an investment-grade option or RidgeWorth Seix High Yield Bond Fund (ticker: SAMHX) for a junk bond option.  I further suggest that regardless of portfolio size, one only invest in junk bonds through a fund in order to reduce risk.  I recommend that any portfolio have at least 25% in bonds.  Graham recommended that most investors would find a balance of 50% bonds and 50% stocks favorable over the long-term – advice that looked foolish in the last cyclical bull market, but looks quite wise to anyone who has checked their portfolio balance in the last year.

So What’s the Rub?

In short, it is up to the individual investor.  Investing in well-managed, low-PEB stocks with strong long-term potential, or alternately transfering (or remaining) in a bond-heavy portfolio are both safe options with excellent growth potential.  The bond route – of course – offers slightly less risk given current valuations, as well as less overall risk from a protracted downturn or high percentage default/bankruptcy scenario.

The most important lesson is that there are always values to be found in the markets – one just has to know where to look.