With the stock market correcting off of its April highs it is once again worth taking a look at the market valuation backdrop.  Why?  Day and high-frequency traders need not worry about valuations but long-term investors should take note.  Back on October 8, 2009 we wrote:

There are some indications that the risk culture has returned to Wall Street.  From that perspective it seems we have entered a more normal phase for the market where risk-seeking has replaced risk-aversion.  As we have said before the market is going to do what is going to do, but the above charts indicate investors need to be a bit more discriminating than they were just a few short months ago.

The S&P 500 closed at 1065.48 that day, yesterday the S&P 500 closed at 1074.03.  The market had a nice run in the run-up to April, but has corrected back to levels seen nearly eight months ago.  Excluding dividends, pretty much a wash.  So where does that leave us today?

Based on the ratio of total market cap to GDP from GuruFocus the market is pretty much fairly valued.*  According to the Morningstar Market Valuation graph stocks are once again somewhat undervalued.

Source:  Morningstar.com

By this measure the market is more attractively priced than we wrote back in October.  This echoed in some comments that note “clear value” has emerged in the market.  While some might argue that the market does not deserve to reach historical valuations it is hard to argue with the pace of earnings growth year-to-date.

Jeff Miller at A Dash of Insight argues we should pay attention to this surge in earnings estimates.  He argues that forward earnings serves as a good indicator of investor sentiment.

The current yield on forward earnings is 7.85%, a rate close to that offered at the market lows of February to March of 2009…By this measure, the market is just as cheap as it was at the time of the 2009 lows.

Other models are also signaling better times ahead. Mark Hulbert at Marketwatch highlights two long-standing market models that have moved into positive territory:

Interestingly, both are quite bullish. Eisenstadt tells me that his model is currently forecasting a 20% return for the S&P 500 index [..] over the next six months. Fosback reports in the latest issue of his newsletter that his model is forecasting a 26% total return for the stock market over the next year and a 75% five-year return (equivalent to around 12% annualized).

One area where a number people seem to be finding value is in large quality US stocks.  Returning to the Morningstar model those companies that they characterize as having “wide moats” are currently more undervalued than the market as as whole.  Noted market analyst Jeremy Grantham* while skeptical of the overall economic situation is on record for some time now saying these quality stocks have been left behind in this rally.

One can currently buy some household names (like Procter & Gamble) with dividends yields at or in excess of Treasury notes.  As Vincent Fernando at The Money Game writes:

In the end, you have to park your money somewhere, and given the concerns regarding currency weakness and inflation, plus worryingly-hyped commodities, perhaps defensive non-financial non-cyclical entrenched companies at historically cheap valuations are the real safe-havens right now.

For the more adventuresome there may be opportunities in the wreckage that is Europe.  Bill Hester at Hussman Funds surveys the global valuation backdrop and finds that international markets are favorably valued against what can only be described as an overvalued US stock market.  He writes:

The graphs show that relative to the US, most international markets are as favorably valued as they have been in the last 40 years (alternatively, the U.S. is about as overvalued relative to international markets as it has ever been).

In the end the market valuation backdrop only sets the tone for trading activity.  The past decade has done nothing but show us that markets can become unhinged from reality both on the upside and downside.  The stock market has not done much the past eight months.  However investors who have honed their stockpicking skills can use this market downturn as an opportunity to start researching ideas with a clear margin of safety.

*See this new post from EconomPic Data that also takes a look at the S&P 500/GDP ratio and finds the market modestly undervalued.

**Update:  new link that better reflects Jeremy Grantham’s current views.

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