After All That, Stock Market Finally At Fair Value

01/01/2009 05:12 am ET | Updated May 25, 2011

After thirteen months of a historic stock market plunge (yes, the worst since the Great Depression), occasionally interrupted by the usual sucker's rallies (of which last week's move may be the latest or may be the start of a recovery), the stock market is, finally, back to a rough approximation of fair value.

The best measure of fair value is the "cyclically adjusted P/E ratio," which smooths out the fluctuations in corporate profit margins by averaging earnings over 10 years. (The straight P/E ratio, based on one year's earnings, can be wildly misleading: when profit margins are high, P/Es look comfortingly low, and vice versa. Profit margins are highly mean-reverting, so the cyclically adjusted P/E gives a far more accurate picture of market value).

The cyclically adjusted P/E ratio is used by Robert Shiller, Jeremy Grantham, John Hussman, Andrew Smithers, and other analysts. As with most valuation analyses, the underlying assumptions are debatable (e.g., will P/Es be higher in the future than they have been in the past?), so estimates of fair value differ. But most of these folks put fair value for the S&P 500 in the 850-1050 range, and Smithers puts it right at 900.

Andrew Smithers' most recent chart showing the S&P 500 relative to its own average on two valuation measures: cyclically adjusted price-earnings (CAPE) and Tobin's Q, which is a measure of replacement cost. The chart is from early October, when the S&P 500 level was 909.

"Fair value" (the green line) is fair value because the S&P 500 has historically spent about half the time below that level--often after spending many years above it. Given the cyclicality of this ratio, if I had to guess, we'd say the S&P 500 is in for a decade or two of below-average values, which argues against the idea that we're suddenly going to have a strong, sustainable valuation recovery.

More likely, the bear market that began in 2000 (after an 18 year bull market) will likely continue for another decade or so, during which stocks will occasionally become truly cheap--as they almost did a week ago, when the S&P 500 hit 750.

The good news is that, after 15 years of being overvalued, the S&P 500 is finally priced to deliver an average long-term return: about 9%-10% in nominal terms and 6% after adjusting for inflation. That's nothing to scream and yell about, but it's likely to be a lot better than cash.