Last week marked the third anniversary of the bear market low, and there is compelling evidence that we still have an undervalued market - meaning investors can find cheap stocks.
Even though the S&P 500 Index has nearly doubled off its lows of March 9, 2009, it is still trading at only about 14.1 times earnings, well below its 15-year average of 20.2.
In fact, earlier this month when the markets hit 52-week highs, that was the "cheapest" stocks have been since 1989,according to Bloomberg News.
The index gained 8.6% in the first two months of this year, its best start since 1987. And that came after a rally that added 24% and about $3.2 trillion in value to shares since October.
But after one of the most volatile years on record, nervous investors can't seem to decide whether the glass is half-full or half-empty.
"What you're seeing is a gigantic exercise in behavioral finance," Brian Barish, president of Cambiar Investors LLC, told Bloomberg. "The ability to scare the hell out of people is much greater than the ability to attract them to equities."
Higher Corporate Earnings Create Cheap StocksMeanwhile, the government's easy money policies have combined with productivity gains to push corporate earnings to record heights.
Analysts at Standard & Poor's estimate operating earnings will rise from $96.34 in 2011 to a record $104.82 in 2012.
That would represent a 72% increase in earnings since 2010. By comparison, the stock index has recorded a 21% gain during the same period.
S&P analysts say earnings will climb to another record of $111.73 in 2013. But they project higher corporate earnings will drop the P/E from 14.1 to 12.2.
So what is it that's making stocks relatively cheap compared to higher earnings?
Simply put, investors continue to defy logic by shunning stocks and piling into bonds.
Despite record low interest rates, investment-grade bond funds took in a record $3.3 billion during the week ended Feb. 15 while equity funds had outflows of $1.9 billion, according to data provided to Bloomberg by EPFR Global and Bank of America Corp. (NYSE: BAC).
Meanwhile, traders have been bidding up the prices of options that will protect them against stock losses to the highest in four years, according to Bloomberg.
The flight to safety has driven the S&P 500's earnings yield (earnings divided by index price) to 7.3%, nearly a record high.
With the spread between the earnings yield and risk-free 10-year Treasuries about 5.8%,stocks are now cheaper than they were in 2002 or 2008. In fact, the last time the spread was this lopsided was 1975, when stock prices jumped 32%.
All this suggests that something has to give. Either Treasury prices will have to plunge or stock prices will have to rise - by a lot.
So what's an investor to do?