Are stocks costly? You make the call

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A sign for Wall Street is shown near the New York Stock Exchange. | AP file

Updated: November 9, 2011 1:51PM

‘Stocks are cheap,” says the guy on TV. No, “stocks are expensive,” says the next guy. They both cite historical patterns as evidence, but why do they reach different conclusions?

It’s all how you define history, I suppose. And choosing which definition to follow could reflect a bias.

The cheap vs. expensive argument goes on endlessly online, with each side having a leading academic for intellectual heft. Wharton professor and author Jeremy Siegel argues that stocks are cheap, telling the Business Insider website last week that they are “25 percent to 30 percent below what I’d call ‘fair market value’ and that might be conservative in terms of earnings power and relative interest rates.”

Siegel based his call on past earnings minus one-time expenses, plus analysts’ projections for the future.

On the overvalued side is Yale University economist Robert Shiller, who correctly described the market bubble of 2000 and the housing bubble that began to burst in 2006. He wrote a book, Irrational Exuberance, that laid out his case for viewing stocks for their 10-year average earnings. The longer time period, Shiller argued, smooths out the business cycles and takes analysts out of the equation. His calculations, posted on his website, show that the S&P 500 is trading at just over 20 times annual earnings averages over the last 10 years, while the longer-term average is about 16. His verdict is that stocks are pricey, but modestly so. According to his index, stocks were more expensive a few months ago before the summer’s declines.

Siegel says the Shiller approach gives too much weight to unusual events in the market, such as the 2008 meltdown. I like it because it acknowledges that “extraordinary” conditions occur regularly in the markets. The unusual is part of its routine.

Adding to this debate is David Bianco, head of U.S. equity strategy at Bank of America’s (BAC) Merrill Lynch, who has amended Shiller’s approach to define earnings differently and modify them with something he calls the Equity Time Value Adjustment. His conclusion — and I know it’s stunning for someone who wants you to buy stocks — is that they are way cheap.

With his talent for making up a financial metric, he should be running the initial public offering of Groupon.

DRIVE ON BY: Sonic (SONC), the chain of drive-in burger joints, is encountering roadblocks, said analysts at William Blair & Co. They downgraded their rating on SONC to the neutral “market perform,” arguing that same-store sales growth is flagging and that inflationary food costs will put pressure on margins in 2012. SONC closed Friday at 7.87.

In a report, the analysts cited a concern about beef prices given the drought in Oklahoma and Texas, “with cattle’s long life cycle creating the likelihood of a multi-year impact.” Sonic, they said, just doesn’t have the power to raise prices.

CHURN, BABY CHURN: It’s a great time to be running an options exchange. Volumes are markedly higher because of stocks’ volatility. At CBOE Holdings (CBOE), parent of the Chicago Board Options Exchange, a record in monthly trading volume was set in August. The CBOE counted 144 million contracts dealt on its systems.

The story is similar with the industry as a whole. The Options Industry Council said 550 million contracts were dealt on the nine U.S. markets in August, a monthly record and nearly double the total of August 2010.

But all this activity might not be good for investors. Options trading proceeds can quickly be eaten up by commissions. I’ve seen many options trading strategies touted that are iffy propositions for the investors, but guaranteed moneymakers for a broker.

Chicago attorney Andrew Stoltmann said heavy options trading in an account can be a sign of broker “churning,” or making trades to accumulate commissions. Stoltmann, who sues brokerages, said he has seen cases in which a third of what the investor spends on the options goes out as a commission or a markup. “No investment pays brokers better than options,” he said.

Other signs of churning, he said, are a turnover rate of at least two times the value of the account, in-and-out trading of a stock, repeated trading of a single stock and heavy activity in mutual funds or bonds, investments that can have hidden markups.

So if you have a broker-controlled account, watch those statements.

“The No. 1 rule I’ve seen is that the commission dictates the investment that’s being recommended,” Stoltmann said.

CLOSING QUOTE: “We spent trillions on foreign wars and allowed our physical infrastructure to deteriorate and our technological infrastructure to fall behind that of the rest of the developed world. We ignored the increase in inequality and laughed off the decline in U.S. manufacturing. We fed a credit bubble that would eventually pop our economy and ran up the debt and eased monetary policy in ways that would make an effective countercyclical response almost impossible. Our problems today are not the result of Sept. 11, but they are in many ways the result of Sept. 12.” — Ezra Klein, Bloomberg News columnist