There is nothing more dangerous than investing by looking in the rear view mirror. A short sighted investor will say that because he has earned nothing in stocks over the past few years, that he should sell all of his stocks and own bonds. Sell low and buy high.
We have to remember that a stock doesn’t remember what you paid for it. What it was worth two years ago or two minutes ago is irrelevant to what it’s worth today and going forward. Over time, the only drivers of a stock’s price are valuation and context. Value always rises to the surface. Value is created by rising earnings, an improving balance sheet and cash being returned to shareholders via dividends or buybacks. Valuation of a stock then depends on context. What are interest rates paying? What is inflation like? What is the overall P/E of the market? These are a few of the questions that need to be asked to figure out if a stock is over or under valued.

Let’s ask these questions now.

What is the overall P/E of the market? Consensus estimates are for S&P 500 cumulative earnings to hit $96 in 2011 and over $100 in 2012. At its current price of 1,280, the S&P 500 is trading at an average of 12.8 times 2012 estimated earnings. Over the past 50 years the average S&P P/E multiple has been around 15 times. Compared to the median P/E multiple, stocks look attractive.

What are interest rates paying? Next to nothing is the answer. In the U.S., five year treasury bonds are paying 1.2%. Canadian savers get a more generous 1.6% for handing over their money for five years.

What is inflation like? In Canada inflation is running at 3% in the U.S. the inflation rate is close to 4%. Inflation is running much hotter this year than many expected.

Let’s put it all together. After tax and inflation, bonds are paying a negative return. Stocks are cheap on a relative basis and if you own a dividend paying stock, chances are you are being paid a lot more than a government bond offers.

Those investing with their eyes focused beyond the windshield would overweight dividend paying stocks trading at P/E multiples of 12.8 times 2012 earnings or less.