It takes faith to invest. Photographer: Jin Lee/Bloomberg
It takes faith to invest. Photographer: Jin Lee/Bloomberg

One of the elements of modern punditry that continually surprises me is the insistence that stocks are grossly overvalued.

As I have written repeatedly, stocks are more or less fully valued. However, since we don't know what next year's earnings are going to be, stocks can get cheap or expensive pretty quickly. It depends on whether earnings slow or accelerate. Although we don't know what is going to happen, investors must make a probability assessment as to the possibilities. (More on this later).

It is true that stock prices are somewhat elevated relative to next year’s earnings estimates, which are typically too high. We also know this: Prices are nowhere near the highs of the huge stock-market bubble of the late 1990s. As of this week 15 years ago, the price-earnings ratio of the Standard & Poor’s 500 index peaked at an all-time high of 35.97.

Contrast that with today. The current P/E ratio -- the trailing four quarters -- is about 17. A bit high compared with the long-term average P/E of about 15, but not bubblicious. This has led to a steady drumbeat of valuation concerns not only from analysts, but fund managers, pundits, even individual investors. The bulls remain circumspect, the bears emboldened. We have heard about Shiller CAPE (cyclically adjusted P/E) -- now about 24 -- endlessly. Never mind that it has been overvalued 85 percent of the time since 1990. Evidence of exuberance is modest at best.

The main problem we run into is that valuation isn't a timing tool. Overvalued stocks can and do become even pricier; undervalued stocks can and do become cheaper.

That is before we get to the possibility that something -- anything -- could go right. Economic activity might pick up. Interest rates could normalize. Fears of deflation could abate. Corporate revenue might accelerate.

Stocks are somewhat pricey, but that condition has persisted far longer than most people seem to realize. Investors who avoid equities the moment they cross their median P/E ratio will miss opportunities for compounding gains.

The bottom line is that what will happen to equities is a function of an unknown, mainly next year’s earnings growth. Your equity exposure is a function of your future expectations of that metric. Those of you who are bearish are likely expressing the view that earnings will decelerate or fall. Bullish investors expect earnings to accelerate from record levels.

This is what accounts for your investment posture, whether you are aware of it or not.

To contact the author of this article: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.