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Are we drowning in stocks?

Tuesday, 5 Nov 2013 | 1:11 PM ET
A trader works on the floor of the New York Stock Exchange.
Getty Images
A trader works on the floor of the New York Stock Exchange.

Peter Lynch says, "Earnings growth is the most significant indicator of a stock's price performance over time." So, what does it mean when stock prices go up a lot and earnings go up just a little? It means that buyers are paying more for each dollar of earnings.

Most of the time, when buyers pay more, it means that earnings are increasing at a rapid clip and buyers expect today's premium will be justified tomorrow. Higher share prices can also indicate a period of low interest rates which result in what Abbey Joseph Cohen refers to as "clean earnings." She means that the earnings are not muddled by inflation.

The S&P 500 has more than doubled since the 2009 lows and is up nearly 25 percent so far this year. If you recall, the year began with bickering in Washington over tax increases and the sequester. What would you have said had someone suggested it would be a year of 25-percent returns?

Stocks, in my opinion, are not cheap. If the rule is to buy low and sell high, this is not low. On Dec. 5, 1996, Federal Reserve Chairman Alan Greenspan included the phrase "irrational exuberance." The Dow Jones Industrial Average had just pierced 6,000 for the first time. In August of 1997 the Dow flew past 8,000. So what did Greenspan get wrong by calling stocks expensive in 1996? Nothing. He was right. Stocks, by historical measures, were expensive. While earnings were increasing, prices were increasing faster. The lesson is that expensive stuff can become a lot more expensive. We can blame it on supply and demand or the greater fool theory, but the prices went higher.

The cover of The Economist in May of 1999 read "Drowning In Oil." Oil was around $11 per barrel and the article suggested it might fall to $5. It didn't, but everybody hated oil and everybody loved tech stocks and "dot-coms". Imagine if you had sold tech stocks in 1999 and bought oil! People would have said you were nuts — and you would have gotten rich.

Stocks are expensive and are becoming more so every day. This can last a long while. John Maynard Keynes warned that markets could remain irrational longer than you could remain liquid. As I think about the old saws of not fighting the Fed, never buying a lawsuit and markets climbing walls of worry, I remember that market bubbles rarely occur when the consensus is worried about bubbles. A lot of folks have been talking about bubbly prices of late. It's usually after the naysayers are dismissed forever as being old-fogy, pessimistic doom-and-gloomers that the bubbles eventually pop.

I have no ideal if stocks will be up or down 20 percent over the next twelve months. If I recognize high valuations, then it is no time to be aggressive. Solid balance sheets with high returns on equity, strong management teams and consistently growing earnings make most sense. Singles and doubles make me happy. You don't want to be the guy without a seat when the music stops.

—By Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor.

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