in a zone of reasonableness

As bulls and bears fight it out over Dow 16,000 and S&P 1,800, and Carl Icahn says he’s cautious on equities (but doesn’t want to predict where stocks will go in the short term), Warren Buffett is sticking to the middle of the road.

He told CBS This Morning:

“I would say that they’re in a zone of reasonableness. Five years ago, I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced. Most of the time, they’re in an area where maybe they’re a little high, a little low, and nobody really knows exactly. They’re definitely not way overpriced. They’re definitely not underpriced.”

[via trbabyb]

10 numbers investors should know

Savvy stock pickers know that a few simple formulas and a little math can reveal the difference between a buy and a bust. Here are 10 key investing ratios, what they mean and how to use them.

stocks are cheap? / stocks are expensive?

Despite hovering around record highs, stocks are "cheap on stock valuations alone," said billionaire buy-and-hold investor Ron Baron in a CNBC interview on Friday from his annual investment conference in New York City.

To make his case, Baron provided a history lesson: "From 1999 to now, companies' earnings have about doubled. And the stock market is up 20 or 30 percent. From 2007, it's up maybe 10 percent. People say how much it's up, but it's only up from where it crashed."

As for valuations, he said on Squawk Box that at the height of the Internet bubble "in 1999 the stock market was selling for 33 times earnings." Stocks are now selling for around 14 times, he said. "They're cheap on stock valuations alone."  [well cheaper than 1999 anyway]

*** [11/23/13 from the December Profitable Investing]

Objective signs of an overvalued market have been with us for some time. On a number of occasions, I’ve called your attention to the Cyclically Adjusted Price–Earnings (CAPE) ratio, devised by Prof. Robert Shiller of Yale. To smooth out the sharp earnings fluctuations that occur around recessions, the CAPE ratio takes 10 years of corporate profits and adjusts them for inflation.

As you can see from the chart, the Shiller P/E now stands at more than 24X. Since 1881, this benchmark has averaged 16.5X. Merely to return to fair value, the S&P 500 index would have to drop approximately 32%, to around 1200. An undervalued reading, at 12X, would take the S&P down to less than 900 (from a recent high of 1798).

While I don’t expect to see either 900 or 1200 in the near future, the increasingly noisy “bubble babble” among institutional investors tells us something. Many influential members of the Big Money herd are already nervously pawing the ground. Sooner or later, some incident, perhaps quite minor in itself, will arouse a critical mass of fear among the leading animals. A selling stampede will result.

flashing red

In the go-go days of 1999, Warren Buffett grew very concerned.

Not because his value style of investing had grown unpopular, but because investors were becoming delusional in their zeal for further gains.

In a speech he made to friends, as recounted in a 1999 article in Fortune magazine (that was published just a few months before the market peaked and then plunged), Buffett warned that "once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks."

A simple test of how much stocks were loved: The aggregate value of the largest 5,000 U.S. companies (as measured by the Wilshire 5000) exceeded the GNP of the U.S. economy. In fact, a market melt-up took this ratio up to 150% by early 2000 (meaning the Wilshire 5000 was 50% larger than the U.S. economy), which set the stage for one of the most painful corrections ever for investors.

This ratio eventually dipped well below 100%, which for Buffett has been seen as a time of deep value for stocks. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you," he told Fortune in a 2001 follow-up.

Indeed stocks went on to deliver solid gains into that decade, but by 2007, Buffett's handy ratio again flashed red. Stocks were becoming so frothy that this measure once again exceeded 100%. The resulting market blow-off in 2008 was another painful lesson for investors, but at least put the market deep into value territory, setting the stage for the bull market we've been enjoying ever since.

Yet as we head towards the end of 2013, investors need to once again tread cautiously, because Warren Buffett's market valuation tool is again in the red zone. [109%]

The Wilshire 5000 has risen 68% since the end of 2009. Yet the economy has grown just 17%, throwing this key ratio out of whack.

Action to take: The Wilshire-to-GNP ratio is stretched, but it could well go even higher for a while, as was the case in 1999. Yet a clear margin for error has been removed from this market, and there is ample reason to shift your portfolio into a defensive posture. That means missing out on further upside in the aggressive growth segments of the market, but also means a greater chance of capital preservation.