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Stocks Keep Falling, But Key P-E Models Say They're Cheap
Friday July 23, 7:00 pm ET
Ken Hoover

Corporate profits are hitting record highs while the stock market is down for the year. That can mean only one thing: stocks are getting cheaper.
The 12-month trailing P-E ratio for the S&P 500 hit 17.7 on Friday, the lowest since 1996. That's based on S&P's estimate of $16.21 a share for the quarter ending June 30, which is up from a $15.87 preliminary reading for the quarter ending March 31.

The valuation on the S&P 500 isn't a historical low, but it's well below the highs of the bubble years, when it soared above 25. It hit 45 in 2002 as earnings were sinking.

In fact, the S&P's P-E ratio, based on operating earnings, is below the average of 20 going back to 1988, but still above the average of 15.6 going back to 1935.

"It's hard to characterize the market as cheap," said Nick Bohnsack, an analyst for International Strategy and Investment. "We think stocks are fairly priced."

Poor Market Timer

Watching the market's P-E ratio is a poor timing tool. A market that is cheap can get a lot cheaper. And a market that seems overpriced can rally for years.

"It's more of a directional thing," Bohnsack added. "When measures get to extremes, there's a tendency for those measures to revert to the mean. When they get blown out in one direction, there's room for directional change."

Right now, the market's direction is due south. The S&P 500 has fallen 4.8% so far this month. The Nasdaq has sunk 9.7% in July to a nine-month low.

But while stocks have marked time, S&P 500 earnings have climbed at least 20% for four straight quarters.

Thomson First Call says when second-quarter earnings are all in -- despite some high-profile disappointments -- they could be up 25%.

The general market's P-E ratio has been fluctuating at a higher rate in the last couple of decades, with low points getting higher and high points higher still. Still, it tends to be at the low end of its range just before major moves up.

In September 1990, just before the start of a new bull market, the S&P 500's P-E ratio fell to 13.03. It stood at 14.47 at the end of 1994, again just before a long and profitable uptrend began.

And it stood at 17.79 in March 2003, just before a yearlong rally began.

Some analysts factor in interest rates when studying P-E ratios to determine whether the market is overvalued or undervalued. Looking at the market that way, the picture is downright rosy. The market is 30% undervalued.

The standard way of doing that is to use the 12-month I/B/E/S consensus estimates for the S&P 500 to arrive at the market's forward-looking earnings yield. The earnings yield is the inverse of the P-E ratio.

It turns out that over the long haul the S&P's earnings yield tracks the yield on the 10-year Treasury note closely. But in the short run, they can get far out of whack.

It's known as the I/B/E/S Model or the Fed Model because Fed chief Alan Greenspan has been known to keep an eye on it. Edward Yardeni, chief economist at Prudential Financial, has popularized the model over the years.

When the earnings yield is higher than the bond yield, stocks are considered undervalued. When it is below, they are overvalued.

With an I/B/E/S estimate of $69.69, the earnings yield would be over 6%. That makes stocks better than 30% undervalued compared to Treasury bonds.

"To equal today's bond yield, the S&P 500 would have to rise to 1634," wrote market strategist Don Hays in a recent report. He sees the market rising 16% to 32% in the second half of the year.

Again, the I/B/E/S Model can't be used alone for timing the market. And today's relative undervaluation doesn't mean the market is going to go straight up from here. But the market, by that measure, was 20% overvalued just before the 1987 crash and 60% overvalued in early 2000, just before the bear market began.

It was 30% undervalued in June 1980. One of the most powerful bull markets in history began -- in August 1982. June 1980 would have been too soon to buy.

One factor that could reduce the undervaluation is that if earnings expectations declined. And there might be some danger of that.

Wall Street has long expected profit growth to slow down to the midteens in the second half. But only recently have investors really started to believe that.

On July 1, analysts expected third-quarter earnings growth of 14.8%. On July 23, they forecast 15%. Long term, that's good: Normally analysts ratchet down overly optimistic forecasts by a few percentage points during a quarter. But over the past year, especially in early 2004, analysts raised profit views -- sharply -- because they underestimated the strength of the economy.

Likewise, of the 260 S&P 500 firms reporting so far, they've beaten second-quarter estimates by 4.1%. That's better than the 3% average since 1988. But for the prior five quarters, companies have topped views by at least 5%.

Rising interest rates would also reduce stocks' undervaluation by making Treasuries more attractive.