By Alexis Xydias and Michael Tsang

BENJAMIN Graham, the father of value investing and mentor of Warren Buffett, would find most US stocks expensive even after the Standard & Poor?s 500 Index dropped 56 percent in 17 months.

Graham measured equities against a decade of profits to smooth out distortions, a method that shows the S&P 500 trading at 13.2 times earnings, according to data compiled by Yale University Professor Robert Shiller.

At the bottom of the three worst recessions since 1929, the average ratio fell below 10. To reach that level, the S&P 500 would sink another 27 percent.

The rout set off by the sub-prime-mortgage collapse in August 2007 has fooled investors, from Legg Mason Inc. money manager Bill Miller to Traxis Partners LP?s Barton Biggs, who said shares were cheap as they continued to fall.

Even Buffett, the billionaire chief executive of Omaha, Nebraska-based Berkshire Hathaway Inc., who worked for Graham in the 1950s, was taken by surprise. He said he was buying on Oct. 17. The S&P 500 lost 28 percent since then, ending March 6 at 683.38.

?We are in a depression, therefore I would expect Graham?s and Shiller?s earnings ratios to get down to a single figure,? said Robin Griffiths, who first studied Graham in 1966 and helps oversee $15.5 billion at Cazenove Capital Management in London.

?If it is a bad depression, it could take the S&P 500 to 400 or 500. It is clearly becoming better value as the market comes down, but it is nowhere as cheap as it can get.?

The S&P 500 added 1.4 percent to 692.8 as of 10:16 a.m. Monday in New York. Energy companies gained as oil rose to a six-week high.

Graham, who died in 1976 at 82, and David Dodd laid out the principles of value investing in Security Analysis, the 1934 textbook used by Buffett to help transform his Omaha, Nebraska-based company into an investment firm with a market value of $112 billion. Dodd died 21 years ago at 93.

Value investors seek out companies priced below their forecast of future earnings to compensate for the possibility of losses. The discount represents the so-called margin of safety that Graham?s followers demand before buying a stock.

Graham avoided calculating values according to a single year of profits, instead urging investors to examine periods as long as a decade to erase anomalies.

During the worst bear markets, stocks don?t reach ?bargain basement prices? until they fall to 10 times profit or less using Graham?s method, according to James Montier, Societe Generale SA?s London-based global equity strategist. That translates to a price of about 500 for the S&P 500, based on combined per-share earnings of at least $50.

Buffett, 78, who attended Graham?s Columbia University classes and worked for him at New York-based Graham-Newman Corp. in the 1950s, misjudged the severity of the credit market freeze, which spurred the first simultaneous recessions in the US, Europe and Japan since World War II. Bloomberg