A perspective on the overvalued / undervalued debate

Here is a link to an article from economist Scott Grannis, who writes the very insightful Calafia Beach Pundit blog.

In it, he adds to his ongoing argument that equities are not currently overvalued, using evidence including the forward earnings ratio of the S&P 500, which has been higher than corporate bond yields for the past year.

The earnings yield is the inverse of the PE ratio, and represents the percentage of earnings each dollar invested in a stock represents. Earnings yields are typically lower than bond yields, because investors are compensated by the potential for earnings growth in a stock (a potential which a comparable bond does not possess). The fact that earnings yields for stocks are now generally higher than the yields of comparable bonds indicates that investors have a very pessimistic view of the potential for future earnings growth.

Other market observers, such as Morgan Stanley equity strategist Adam Parker, have recently argued the opposite position from Mr. Grannis, saying that the market may be overvalued. This Wall Street Journal article explains Mr. Parker's position, which says that while large-cap stocks in the S&P may be cheap, the rest of the index is slightly overvalued. Mr. Parker also believes that estimates of future earnings are too high and "seem likely to fall back to earth," according to the Journal report.

Our position is that trying to predict the next price move -- or the next earnings trend -- of an entire index is a fool's game, and that such exercises fall into the same trap of failing to focus on individual businesses that is the hallmark of Modern Portfolio Theory (which we recently discussed in this post).

While it is useful to look at overall earnings yields and it is also useful to know that large-cap companies have not participated in the positive price move of the past two years to the same extent that smaller cap companies have, we do not advise that investors take that information and try to time the market with it, either by shifting from stocks to bonds based on such statistics, or by shifting from small-cap to large-cap names either. All of these are common techniques of investment processes that focus on large categories, sectors, or indices rather than on individual businesses themselves.

We agree with Mr. Grannis that stocks in general are not overvalued at this time, and we would use that information to encourage investors to continue regular, systematic investment into the securities of well-run, carefully selected businesses. With such regular and systematic investments, investors will be able to buy more of an investment when securities are undervalued, and will buy less when markets are overvalued.