Prices Are All You Can Rely On

 | Aug 14, 2013 | 5:30 PM EDT
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Ascertaining the state of the stock market is a task that provides limitless opportunities for economist, analysts, investors, and other academics to draw conclusions. But of course, no one really knows, and everyone will always have a 50/50 probability of being correct.

When an analyst is correct, he is revered for a few years until he inevitability calls "tails" when he should have called "heads." During the Internet bubble, Henry Blodget earned his fame when he gave a Buy recommendation on Amazon (AMZN) despite its nosebleed valuation. Amazon shares surged, and Blodget was considered a tech god, at least for a while.

A few years ago, Meredith Whitney was an unknown analyst who predicted a dire forecast for Citigroup (C) back in 2007. Her call proved unbelievably timely, as we all well know. Whitney became a household name, at least in financial circles. Her most recent prediction, the collapse of municipalities, has yet to really materialize, unless you are talking about Detroit.

So what is the best way for investors to derive their own conclusions with respect to market valuation? The only numbers you can really count on are prices. Prices determine valuation, but unfortunately, that's where it stops. Valuation is not static across the board. Prices are why Chipotle Mexican Grill (CMG) can trade at 42x earnings, Apple (AAPL) trades at 12x earnings and Google (GOOG) trades at 25x earnings.

If you buy at the right price, you can buy at the market top and still do well, just as buying at an inflated price during market bottoms may not turn out well. Generally speaking, however, when markets are in decline, the general stock market tends to offer more attractive prices, and that is why everyone and their aunt has made money the past four years. When markets are marking new highs, as they seem to be today, the availability of attractively priced securities shrinks tremendously.

So where are markets now? I don't know, but I will share some numbers with you that could help you determine what inning this rally is in.

According to Value Line, the median price-to-earnings ratio of the stocks it covers (about 1,700, comprising 95% of total market cap) is 18. At the market bottom in March 2009, the median P/E was 10.3. The median dividend yield today is 2.1%; at the bottom it was 4.0%.

The folks at Value Line also like to estimate the median appreciation potential of stocks. Today that number is 40%. Before you go out and start buying, thinking 40% is a great return, consider that at the market bottom, the median appreciation potential was 185%.

These are very elementary figures, but they reveal a lot, namely that markets are leaving attractive territory and going into the speculative. My opinion is reinforced by the fact that interest rates are being kept low, and that has clearly had a mighty hand in pushing the stock market up. Some profit-taking may not be a bad idea.

That being said, the Federal Reserve can continue to be helpful for years to come, and in 1999 the P/E ratio of the S&P 500 peaked at 44. Regardless of what you do, remember that prices are the only thing you can count on.



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