Is the stock market actually cheap?

In my view, it’s not so clear that this is the generational buying opportunity some of the bulls seem to think it is.

Let’s take a look at market valuations. This is where the cyclically-adjusted price/earnings ratio (“CAPE”) comes in handy.

The CAPE was made famous by Yale professor Robert Shiller, though Benjamin Graham – Warren Buffett’s mentor and the father of value investing – suggested a similar methodology as far back as the 1930s.

Rather than compare stock prices to current-year or expected next-year earnings, the CAPE compares prices today to a 10-year average of earnings. The idea is that any stretch of a decade has likely seen a boom, a bust and everything in between.

Selloff Dynamics

The S&P 500 started February with a CAPE of 33, putting it roughly at the level of the 1929 pre-Depression top. The CAPE has only been significantly higher once in the entire history of the American stock market, and that was at the peak of the 1990s tech bubble.

The bloodletting we saw in February and March took a lot of the speculative froth out of the market and knocked the CAPE down to about 23. It’s since recovered to just shy of 26 as I write this.

A CAPE of 26 looks a lot better than a CAPE of 33. But it’s far from cheap.

To put it in context, the CAPE was sitting at roughly these levels at the 2007 top. The CAPE bottomed in 2009 at 13, literally half of today’s levels.

Market Outlook

Data site GuruFocus ran the numbers and found that a starting CAPE value at today’s levels suggests annual returns of just 0.9% over the next eight years.

Take this with a grain of salt, of course. Interest rates and inflation are both lower today, meaning that stock prices should be higher, all else equal. (Lower interest rates reduce the time value of money). And it’s also worth noting that the S&P 500 is dominated today by high-margin tech companies with quasi-monopolies. Again, all else equal, this suggests that stock prices should be higher today than the historical average.

But, in my opinion, even allowing for some generous wiggle room, it’s hard to really call the market cheap here.

Does this mean that the market has to retest its lows or plummet to new depths?

In my opinion, absolutely not. The market doesn’t have to do anything, in my view. But, to my way of thinking,, it does mean that the S&P 500’s annual returns will likely be below average over the better part of the next decade.

The following is an excerpt of Is the Market Actually Cheap?, which first appeared on Money & Markets.

Photo Credit: thenails via Flickr Creative Commons