Stocks Are Cheaper, But Not Cheap

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Stocks are a lot less expensive than they were two weeks ago. Unfortunately, they are still far from cheap.

The S&P 500 has fallen 10% from the record it hit last month, and if you want to point fingers at reasons why thereare plenty of targets. Worries over how much the Federal Reserve will have to raise interest rates certainly helped getthe tumble going ( The wipeout inproducts that bet against volatility ( played a role as well. So might the automatic dumping of stocks by some so-called risk-parity funds( Theexpected swelling of the budget deficit ( as a result of tax cuts and a new budget deal certainly didn't help either.

But the thing that made the stock market vulnerable in the first place was its price. At its peak last month, the S&Ptraded at 18.5 times expected earnings, according to FactSet, reaching its highest level since 2002. Since then it hasfallen to 16.9. That is still high--the median level over the past 20 years is 15.2. Moreover, while for much of lastyear it was possible to argue that the market's high forward price/earnings ratio was justifiable since it didn'treflect the possibility of corporate tax cuts, that is no longer the case. Analysts have now largely incorporated theminto their estimates. There is now even a worry they have been too optimistic, failing to recognize how much of theextra cash from corporate tax cuts will end up getting spent on wages and other costs.

No valuation measure is perfect, but other stock market yardsticks also remain rich. As a percentage of gross domesticproduct, the value of U.S. stocks remains near levels last seen in 2000, which by many measures was the most expensiveperiod on record. The cyclically adjusted P/E popularized by economist Robert Shiller is at levels only eclipsed justbefore the 1929 crash and in the years surrounding the dot-com bubble.

The problem with high valuations when stocks falter is that they make it harder for investors to gain the confidenceto step in and buy. Adding a further complication, rising Treasury yields are taking away the excuse many investors wereoffering for high stock valuations. Bonds are now a more viable alternative. Furthermore, since tax cuts and increasedgovernment spending seem likely to make an already tight labor market throw off more heat, the Fed seems unlikely toback off on raising interest rates for the sake of fretful investors (

None of this means stocks are doomed to keep on sliding, though they might. But investors have gotten a lot morenervous, and it seems that they probably should be.

Write to Justin Lahart at (

-Justin Lahart; 415-439-6400;