Puzzling over whether stocks are cheap or pricey requires examining multiple measures and putting them in context. As Dave Sandstrom explains in a Money Talk Video interview with Joel Dresang, investors need to see the bigger picture.

Joel Dresang: Dave, when we’re talking about stock prices, we’ve seen the indexes at record levels for a couple of years now. What is that telling us about how expensive stocks are?

Dave Sandstrom: Joel, I think it’s important not to confuse stock levels with valuations. I think it’s important to separate the two because just because the index is at an all-time high doesn’t mean stocks are necessarily expensive. So we need to look at valuations most importantly.

Joel: Can you explain what valuations are?

Dave: Well, when we buy a stock what we’re buying is a piece of a corporation and the rights to a future stream of incomes or earnings from that corporation. We then need to discount that back into a present-day value to determine, okay, what am I getting for buying that stock?

Joel: So typically you look at the price-earnings ratios?

Dave: That’s a very popular measure. There are several. And what that tells us is, okay, now that I’ve determined the value of those future earnings today, now how do I compare with other companies? I do that by dividing that into the price for that share of stock.

Joel: So what are those valuations telling us about how expensive stocks are?

Dave: Well, if we look at the long-term average of let’s say the S&P 500, it’s in that 15 range. And that tells me that investors have been willing to spend $15 for every $1 of earnings that they receive from that company. For the last few years, we’ve seen compelling deals out there and PE ratios have been lower than that, and we can no longer say that.

Joel: And what about interest rates? What difference does that make?

Dave: Well, it’s important to look at the big picture. We can’t just focus in on that PE ratio alone. We have to look at the broad context of everything else around it. When I talked about that average of the 15 PE ratio, that also takes into consideration average interest rate levels. We’re certainly not at average interest rates levels.

Joel: We’re historically low.

Dave: Historically low. So taking a smaller discount because of the low interest rate would help substantiate a more expensive PE at this point.

Joel: Does where we are in the business cycle have any context for that, too?

Dave: That’s an important thing to look at. I don’t think you should get too caught up in looking at just a single indicator, like a PE ratio.

Again, part of looking at the big picture here, are we at a point in the business cycle perhaps where expansion’s ahead of us and there’s still a lot of future growth in the system that could help substantiate those higher prices?

Or, are we at the end of the business cycle, where we’ve kind of run our course where maybe interest rates and inflationary pressures are such that those prices are higher and it’s maybe not as attractive?

Joel: And you say that the S&P is historically high, but does that mean that everything’s too expensive?

Dave: No. I think if you look around, I think there’s some compelling bargains still out there, depending on the sectors you’re looking at.

Joel: So S&P 500 is large companies. So there could still be small companies. There could be overseas companies.

Dave: Absolutely. And I think again when you look at the big picture, I think that the valuation measures that are out there – the PE ratio being one of them – is only part of the equation for determining the value or the price of stocks at this point in time.

Joel: So what should investors do knowing all this?

Dave: I think I would look at your portfolio specifically and determine whether or not you feel like you’re overexposed to stocks for your risk tolerance or maybe underexposed. Maybe it’s a good time to peel some of those winners if you feel like you’re a little stock-heavy in the portfolio. Maybe now’s not the time to add additional equities. But I also think it’s not time to head for the exits, so to speak, because of where prices are at.

Dave Sandstrom is a vice president and investment advisor at Landaas & Company.

Joel Dresang is vice president – communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted April 20, 2015)

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