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The market isn’t cheap – buy carefully!

Even in an “expensive” market, there are nearly always opportunities if you dig deep enough to find undervalued stocks that are worth investing in. However as the market heads higher and higher it naturally get harder.

Of course just because the market appears expensive, it doesn’t mean it won’t continue to head higher – perhaps much higher. Without a crystal ball that’s a hard call to make! It’s also why clever investors like Warren Buffett focus on value, not price. As Buffett famously reminds people: “Price is what you pay, value is what you get.”

Recent research by analyst Mr Damien Klassen at listed broker Wilson HTM (ASX: WIG) highlights the fact of just how expensive the market is becoming. A chart provided in this week’s research highlights that the “cheapest” 10% of stocks in the S&P/ASX 100 Index (Index: ^AXTO) (ASX: XTO) are now trading on a forward price-to-earnings (PE) ratio of 11.3. According to Klassen, the tenth percentile of ASX 100 stocks has only been on a PE above this level twice in the past 20 years — the previous two occasions being prior to the tech boom and prior to the financial crisis.

A further chart in Klassen’s research highlights this disconnect even further. Since June analyst forecasts for financial year (FY) 2014 earnings per share have been trending lower, however the forward PE ratio has been increasing. For example consider the disconnection between companies such as Seven Group (ASX: SVW) which guided for significantly lower earnings in FY 2014 and yet has seen its share prices rally.

Foolish takeaway

While savvy investors can nearly always find an undervalued stock somewhere if they look hard enough, it is important to not get swept up by the ‘thundering herd’ of the market. Momentum would certainly seem to be towards the upside at present which can make it worthwhile to let your profits run, however when data such as that outlined by Klassen suggests the overall market has few cheap stocks – amongst the large caps at least — it may be unwise to be aggressively buying in.

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Motley Fool contributor Tim McArthur owns shares in Wilson HTM.

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