Stock values loftier than even during dot-com daze
High PE numbers may be portending market fall
BY DAVID A. SYLVESTER
Mercury News
www0.mercurycenter.com
On the surface, the stock market looks like it has launched into bubbleland again.
The oldest, most basic valuation measure of stocks -- the price-earnings ratio -- soared last week way beyond anything ever recorded, at least since 1872, for the 500 largest U.S. companies.
This ratio for the Standard & Poor 500 index hit a staggering 60 by last Friday, as calculated by Bloomberg News. That's twice the level it reached during the Internet bubble of 2000 and more than three times higher than its historic average.
In other words, investors were willing to pay $60 a share for every $1 a share that companies in the S&P 500 earned during the past 12 months. During the Internet bubble, they were paying $25 a share.
As for Nasdaq, the companies making up the index haven't had enough earnings since last April to calculate any ratio that makes sense. The index of the 100 largest companies on Nasdaq is showing a loss of $145 a share for the last 12 months, according to Bloomberg News.
Even at the peak of the bubble, despite the money-losing dot-coms, the Nasdaq index showed a profit of $12 a share, according to Bloomberg's data.
What's going on?
Earnings have fallen faster than stock prices on a percentage basis. Interest rates also are declining, so there's not much competition from interest-bearing investments. And investors remain optimistic.
``Stocks ain't cheap,'' said Paul McCulley, managing director at Pacific Investment Management Co. that specializes in bonds and fixed-income investments.
The high valuations come even though stocks have sagged lower.
The S&P 500 is down 2 percent since the beginning of the year and 17 percent its level of a year ago. The tech-heavy Nasdaq is also down 2 percent for this year and 31 percent below its level of a year ago.
The problem is that earnings have dropped sharply, particularly among tech companies, since the end of 2000. Silicon Valley, for instance, is still bleeding red ink, especially from one-time write-offs of inventory and ill-fated acquisitions.
So far, 230 Silicon Valley companies have reported earnings for the fourth quarter of 2001 -- and the results, including one-time charges, add up to a loss of $4.3 billion, 9 percent greater than the loss of $4 billion for the same group a year ago.
Sky-high price-to-earnings ratios are reviving the debate about how to determine the value of stocks.
The reasoning behind the PE ratio is that shares of a highly profitable companies are worth more than those in a less profitable company. But Wall Street analysts usually look not just at the earnings of the past year but at those for the coming year to estimate how fast earnings are growing.
Now, analysts are expecting earnings to pick up sharply enough to make the apparently high PE ratios return to earth.
Normally, earnings increase quickly as an economy comes of a recession, so that the PE ratio falls. During the 1990-91 recession, the ratio rose from about 15 to the mid-20s as earnings eroded. It then drifted back down to 15 during the next four years as earnings improved.
In the same way, earnings are expected to pick up as this recession ebbs. According to research firm First Call/Thomson Financial, the consensus is that earnings will rise nearly 16 percent this year compared to last year.
Yet these estimates could be too optimistic, if there is a weak economic recovery, reports Chuck Hill, First Call director of research. He estimates earnings might rise by only 5 percent to 8 percent for this year.
Other economists also are skeptical. They note that the Federal Reserve Board remains concerned about risks to the economy from weak consumer and business spending.
``There's an expectation of a vigorous recovery,'' said Janet Yellen, former governor of the Federal Reserve board and now professor of economics at the Haas School of Business at UC-Berkeley. ``I'm dubious, and the Fed has told us that they're worried about it too.''
One of the problems is that earnings are harder to decipher now. The spate of current write-offs and charges make it more difficult to know what true operating losses are. (One-time charges are not included in the PE ratios calculated by Bloomberg News.)
For instance, JDS Uniphase reported a loss, including write-offs, of $2.1 billion in its second quarter ending last Dec. 2. But from continuing operations, it reported only a 2 cent per share loss.
If it had a profit, its PE ratio would be calculated on the per-share figure from continuing operations.
The other problem with the PE ratio is that it does not compare the price of stocks to the most common alternative investment, bonds.
Stocks may be expensive, but interest rates have sunk to a 40-year low so that bond prices are high as their yields have fallen. (Bond prices move inversely to their yields.)
Ken Fisher, chairman of Fisher Investments, who has studied PE ratios back to 1872, calculates what he calls the ``earnings yield'' of stocks. This shows the percent of earnings that stocks are producing, and he finds valuations aren't excessively higher than they have been in the past.
Overall, though, he remains pessimistic on the market and is predicting the S&P 500 will fall by 5 percent this year.
A vocal group of bears believe stocks are overvalued.
Michael Belkin, a forecaster based in Washington state, said the stock market remains mired in a long-term bear market that will end only when investors virtually give up on stocks. The current valuations show that this fit of despair hasn't happened yet, meaning another decline is coming.
``It could happen fast, or it could happen slow,'' he says.
Not necessarily, says Mark Zandi, chief economist at Economy.com.
Zandi did a statistical analysis of the S&P's stock prices compared to the 10-year bond rate and expected earnings. He found stocks are ``appropriately valued'' if corporate profits grow by 7.5 percent and the 10-year Treasury bond yield averages 5.25 percent during this year.
And that is quite reasonable, he says.
His report concludes: ``Current expectations appear reasonable, but given the very uncertain economy they could very well turn out to be wrong. Those expectations would have to be very badly wrong, however, for there to be another significant downdraft in stock prices at least in magnitude sufficient to become a macroeconomic problem.''
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Contact David A. Sylvester at dsylvester@sjmercury.com or (408) 920-5019. |
