The folly of "cheap" and "expensive" stocks.

How to understand Wall Street.
Aug. 19 2004 8:29 AM

The Folly of "Cheap" and "Expensive" Stocks

You think that stock is "cheap"? Would you also like to buy this lovely bridge?

Read Henry Blodget's detailed disclosure statement here; find the Complete Guide to Wall Street Self-Defense here.

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Which brings us to the second problem with valuation: its lack of relevance as an intermediate-term price-prediction tool. Even if we could establish for certain what a stock was worth, this would be no guarantee—or even indication—that the stock would trade there in any reasonable timeframe (or ever). Over the long haul, thankfully, valuation does matter: The market is not random, stock prices do tend to regress to long-term means, and long-term investors are better off buying when stocks are cheap. As discussed in a previous piece, however, the "long term" is long (decades, not years), and valuation is not a particularly helpful prediction tool over timeframes of three months to a couple of years (not worthless—just not particularly helpful).

Take the S&P 500, for example, an index that can be viewed as a stock tied to the biggest companies in the U.S. economy. A glance at history reveals that the index's price often takes eons to regress to its long-term mean. According to data compiled by Yale professor Robert Shiller, from 1881 to 2000 the S&P 500's average price-earnings ratio was about 16 times earnings, with a peak of 44 times (1999) and a trough of 5 times (1920). From this data, one might conclude that the average value of the S&P 500 is 16 times earnings, and, therefore, in years when prices were significantly below or above this level, stocks were "cheap" or "expensive." Judging from the eventual performance of the index, these conclusions would have been right. They wouldn't, however, have allowed one to predict with confidence what the S&P 500 was going to do the following year.

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In 1970, for example, the S&P 500 dropped below 16 times earnings for the first time since 1958 ("Buying opportunity!"). This apparent undervaluation did not, however, signal that prices were about to go up. In fact, 12 years later, in 1982, the index was trading at about seven times earnings (a real buying opportunity), and it did not return to "fair value" until 1986, 16 years later. Similarly, in 1986, if one had decided to sell the S&P 500 on the theory that above 16 times earnings was "overvalued," one would have been even more frustrated. Except after the 1987 crash, the S&P 500 has remained above 16 times earnings ever since 1986. The suckers who refused to pay more than fair value, in other words, missed the last 14 years of the bull market.

Bottom line, valuation is far more difficult to determine and far less helpful in predicting intermediate-term price performance than most commentators think. Next time someone urges you to buy a stock "because it is cheap," therefore, remember that the wise response is probably, "So?"

Next week: If valuation isn't a good near-term price prediction tool, what is?

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