Stock Prices Are Cheap! Valuation Geeks Get it Wrong Again

“Stocks are cheap by historical standards” is the latest fiction being promoted by valuation geeks. Is it true?

Meb Faber, proprietor of the Cambria Global Value ETF (NYSEARCA:GVAL), and a valuation guru tweeted the 5-year CAPE ratio for the usually frothy technology sector (NYSEARCA:XLK) is just 22 today compared to an elevated 96 at the height of the dotcom boom back in March 2000.

Is Facebook (NasdaqGS:FB) cheap when compared to Google 10-years ago? Should we take comfort that Faber says technology “valuation is nowhere near bubble” territory (NasdaqGM:QQQ)?

Unfortunately, 99% of all statistics only tell us 49% of the story.

And that’s why historical comparisons of CAPE  to our era confuses investors, causing them to make poor and ill-timed decisions.

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The CAPE ratio, also known as the “cyclically-adjusted P/E” uses average corporate earnings for the S&P 500 (NYSEARCA:SPY) or another segment of the stock market over a period of time. Stock prices are divided by the average of 5 or 10-years of earnings and adjusted for inflation, giving a truer picture of potential future earnings power. The CAPE ratio is a perfectly acceptable standard of equity valuation and even better versus the traditional price-earnings (P/E) ratio which can be distorted by short-term aberrations.

Why can’t we compare CAPE valuations to history? We can, but with some well warranted skepticism.

You see, corporate earnings (NYSEARCA:DIA), particularly since the Federal Reserve began its giant experiment with quantitative easing in 2008, have been inflated by cheap money and thus badly distorted. Unlike previous eras, today’s stock market valuations (CAPE) aren’t organic, but rather the obvious result of unprecedented monetary stimulus. (Astute observers could even make a case that previous CAPE eras were in their own perverse way uniquely distorted.)

For the rest of us, here’s the point: A stock market that requires monetary stimulus for its daily shot of happiness is a dangerous beast. What happens when the eventual day arrives that the beast doesn’t get its fix? How will the beast react?

The other point is the stock market’s psychology isn’t shaped or motivated by equity valuations alone. Recent history teaches us that much and my recent video titled “Do Stock Market Valuations Matter?” made this point.

In the fall of 2007, the U.S. stock market (NYSEARCA:SCHB) was a bargain compared to the stock market of 2000. But that still didn’t stop stocks from declining almost 50% over the next 18 months. In retrospect, people that used historically cheap P/E or CAPE ratios in 2007 as a reason to buy stocks (NYSEARCA:IVV) were badly misled. Will the future be any different for people who use the same rationale as their guide?

“Beware of geeks bearing formulas,” warned Warren Buffett.

It’s hard to disagree.

The ETF Profit Strategy Newsletter uses technical and fundamental analysis along with market history and common sense to keep investors on the right side of the market. We cover major asset classes like stocks, bonds, gold, and currencies. In 2013, 70% of our weekly ETF picks were winners.

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P.S. Here’s a homework assignment for valuation geeks: Come up with a QE-adjusted CAPE ratio and get back to me.