Katie Lance
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Katie Lance in Economics & Politics,

There’s no reason for stocks to fall any further

After some steep declines, the equity market is now fairly valued

The stock market, charitably put, is at an inflection point.

The S&P 500 Index has fallen 8% from its September highs, when it topped 2,000 points. We’re now back to where we started at the beginning of the year.

The drop has been fast and furious, with the benchmark index recently posting its worst three-day run since the dark days of 2011 amid the European debt crisis. It recorded its worst session of the year Wednesday. The S&P 500 rose 1 point Thursday.

Those previous declines proved to be buying opportunities. Since August 2011, the S&P 500 is up almost 80%.

So where are we at now? Should you buy or wait?

Let’s look at some numbers for context:

Trailing earnings: no cause for panic

The S&P 500’s price-to-earnings ratio, based on the past 12 months, is about 18.

That’s slightly elevated compared with more than a century of historical data. According to financial data website Multipl.com, the S&P 500 has an average P/E of 15.5 and a median P/E of 14.5 based on its trailing 12 months of reported earnings.

However, I don’t care much about stock market data from the 1930s. The advent of electronic trading, the globalization of the American economy and the very different nature of 21st-century technology companies make investing today a different reality.

The bottom line is always performance, and it’s important to note that we saw a great run for stocks in both the 1990s and the mid-2000s with price-to-earnings ratios above this mark.

Forward earnings: fairly valued

More important to me than trailing earnings, which is a view of the past, are future earnings.

And based on Thomson Reuters data, we are right where we should be based on earnings projections for the next 12 months. The chart above shows a 25-year average of 14.9 for forward P/E — and a current reading of 15.

CAPE: signs of trouble

While these previous data sets show there’s not much to worry about, the valuation metric that does have many nervous right now is cyclically adjusted P/E, also known as CAPE or Shiller P/E.

Multipl.com notes the mean CAPE of the S&P 500 is 16.6 and the median is 15.9. We are indeed very elevated from those levels. And we’re elevated compared with the past 25 years or so.

Yale economist Robert Shiller sounded this warning in August, based in part on CAPE calculations. The warning seems prescient in hindsight.

No crystal balls

It’s important to remember that making sweeping statements about valuations based on a price-to-earnings ratio is not an exact science.

A few very important caveats to remember:

Price-to-earnings ratios can differ greatly among stocks in different sectors and at different market values. For instance, Apple AAPL, -1.31% may not be “cheap” with a forward P/E of 13 when compared with other large-cap tech companies. But it’s also not completely safe just because the number is lower than the market at large.

P/E ratios can resolve themselves in two ways: Prices change, or earnings change. Fast-growing stocks that continuously beat expectations may “deserve” a high P/E, while chronic underperformers are not a bargain even at single-digit P/E ratios. Back to Apple, if the company misses the mark in its upcoming earnings report and future forecasts crumble, then the forward P/E will spike even if the shares flatline.

And don’t forget, sentiment matters. If investors are “risk on,” then they may not much care about paying high earnings multiples even for low-growth stocks. If they are “risk off,” then even entrenched giants may not be attractive at single-digit P/E ratios.

On the whole, I think sentiment is weak, so investors may not be overeager at this moment. But given the lack of alternatives and the continued improvement in the U.S. economy over the last few years, I wouldn’t expect investors to run for the hills.

The unfortunate truth, then, is perhaps that the market is at a stopping point rather than an inflection point.

While I am not convinced that stocks will rebound in the next few months, neither am I convinced that we are in a bubble and doomed for a crash.

That means you have to be selective.