Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: Bloomberg.com (for treasury prices), economy.com (for historical inflation), calculations by tylernewton.com

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors, economy.com, calculations by tylernewton.com

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.

Conclusion

Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in www.tylernewton.com are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.