Are stocks cheap or dear?

In 2008 and 2009, investors experienced gut-wrenching declines and breathtaking surges in stock prices. Stocks are still not back to where they were at the start of 2008, but in the meantime, earnings have declined and dividends have been cut. So where are we now, at the beginning of 2010, with regard to price and value? Is there a compelling argument for the enterprising investor to deviate from a standard, balanced allocation?

First, it's instructive to look at economist Robert Shiller's website, which gives a historical glance at a cyclically adjusted price/earnings, or CAPE, ratio of the S&P 500 Index. (The concept of looking at this metric comes from Graham himself, and Grantham, Mayo, Van Otterloo analyst James Montier calls it the "Graham & Dodd P/E" in his book Value Investing: Tools and Techniques for Intelligent Investment.) Currently, the ratio is at nearly 21 times, which seems somewhat high by historical standards, though perhaps not inordinately so, given very low interest rates. The current multiple isn't nearly as high as the roughly 45 times earnings multiple the market reached in early 2000 or the 35 times earnings multiple it reached in 1929, but it doesn't exactly appear to be a bargain basement multiple either. The average multiple for the index since 1881 is 18 times, according to Montier.

Another possible cause for tempered expectations is Morningstar's own Market Valuation Graph, which shows the market to be 5% overpriced currently. That's not an egregious overpricing and certainly not as high as the all-time high of 14%, but it doesn't appear particularly cheap either. If we dig a little deeper into Morningstar's equity analysis, we see that only 35 stocks currently trade in 5-star territory or far enough below the analysts' fair value estimates to offer the margin of safety warranting a buy recommendation.

After sifting through all of this evidence, it appears that the market isn't cheap. In the last edition of The Intelligent Investor, when CAPE was a bit over 17 times, Graham argued against increasing stock exposure, saying, "It is hard for us to see how such a strong confidence can be justified at the levels existing in early 1972." Clearly, he'd say the same thing today at 21 times. In fact, in his other book Security Analysis, he remarked that buying stocks over 20 times average earnings was speculating more than investing, because that meant you were willing to accept an "earnings yield" of less than 5% on a risky asset.

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Several of the successful market gurus I keep an eye on say the market remains attractively valued -- but not all of them.