After The Correction… Are Stocks Cheap?

We finally got that 10% correction we’ve all been waiting for. Last week’s volatility finally put us into official correction territory for the first time since 2011. It also gave us one of the biggest intraday swoons in market history as the Dow dropped by over 1,000 points last Monday.

So after the August carnage, is the stock market finally cheap again?

Not even close.

Let’s take a look at the cyclically-adjusted price earnings ratio (“CAPE”), a popular back-of-the-envelope metric used by many value investors – myself included – to gauge the overall cheapness of the market. And as you can see from the chart below, last week’s carnage barely made a dent.

The CAPE, at 25.2, is still sitting at elevated levels. That’s more than 50% higher than the long-term average. Data site GuruFocus crunched the numbers, and a CAPE reading at these levels implies that returns over next eight years will be a pitiful 0.5% per year.

Now I should be clear here: CAPE is not a forecasting tool with surgical precision. Mixing metaphors a little here, I’d consider it more of a hand grenade than a sniper rifle. This model is designed to give a rough estimate, and I do not for a second believe that annual stock returns will be exactly 0.5% per year. But I’m pretty comfortable saying that, at the very least, we should expect returns to be a little on the disappointing side starting at today’s prices.

Does this mean you should pull all of your money out of the market today?

Not necessarily. The CAPE is a long-term asset allocation tool, not a market timing tool. After last week’s sharp selloff, I actually expect stocks to drift a little higher from here. But viewing this as a portfolio manager, I would say this: The August selloff should be a reminder that stocks are volatile and that a “buy, hold and pray” approach to investing is not always the right one. Don’t be afraid to take a more active approach to your investing… or to put a portion of your portfolio in alternatives outside the market with competitive expected returns.