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How To Play This Improbable Market Anomaly

 February 28, 2012 09:52 AM

Forget what stocks have done for us lately. The S&P 500 Index is up 24.3% since October 3, 2011. Yet investors couldn't care less.

Case in point: Trading volumes on the New York Stock Exchange plumbed the lowest level since 1999 last month. And the latest fund flow data for the week ending February 15 shows that investors plowed a record $3.3 billion into investment-grade bonds, yet yanked $1.9 billion out of U.S. stock funds.

As Jeffrey Saut, Chief Investment Strategist at Raymond JamesFinancial (NYSE: RJF) says, "The world is profoundly underinvested in U.S. equities."

[Related -Is The S&P 500 Triple Top Actually A Bullish Sign?]

But is this a smart investment strategy? Hardly. And here's why…

Up in Price, Yet Even More Undervalued

It's counterintuitive to think an asset could simultaneously go up in price and get cheaper. But that's exactly what's happening with stocks.

The S&P 500 Index closed out last week at a new bull market high. Yet, based on the price-to-earnings (P/E) ratio, stocks are actually about 9% cheaper than they were in April 2011.

How does that happen? It's simple: Corporate profits are expanding faster than stock prices. Since 2009, S&P 500 earnings are up 54.8% versus a 22% price increase for the Index.

Mathematically speaking, we're talking about the denominator in the P/E ratio calculation (earnings) increasing more than the numerator (price). And by the looks of it, this trend is set to continue…

[Related -Sector Detector: Is There Still Enough Fuel In The Bulls’ Tank?]

According to Bloomberg, analysts expect S&P 500 earnings to jump 9.8% in 2012 to a record $104.40 per share.

Now, before you go and dismiss those projections as too rosy, chew on this: Profits topped analyst expectations for 12 straight quarters.

In other words, it's likely that S&P 500 earnings will increase by more than 9.8%. And if the current investor apathy continues, that means stocks could get cheaper still – without actually going down in price.

A Bargain… Even For Pessimists

If you're reluctant to buy stocks based on projections, don't be. Even if we ignore the future – and assume no profit growth – stocks are still cheap. Take a look:

At current prices, the S&P 500 trades at a P/E ratio of 14.3.

Granted, that's not as cheap as stocks were when the market bottomed in March 2009. But it's also nowhere near the frothy valuation we witnessed at the peak of the dot-com bubble.

It turns out that stocks are actually trading about 15% below the average P/E ratio over the last 50 years of 16.4. Moreover, according to Bloomberg, they've traded below the average for more than 18 months, which is the longest stretch since the 13-year period that began in 1973.

Bottom line: I couldn't agree more with Jack Albin, Chief Investment Officer for Harris Private Back, when he says, "If investors focused on the fundamentals and discounted the daunting headlines, stock market values would be substantially higher."

So yes, even after a 24% rally, stocks are still cheap. And it's only a matter of time before other investors wake up to the bargains.

Ahead of the tape,

Louis Basenese



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