P/E Drop May Signal Bear Market End: Taking Stock.................
By Josh P. Hamilton - 07/30 15:21
New York, July 30 (Bloomberg) -- History shows that U.S. stocks have fallen far enough compared
with earnings to suggest the current bear market may be finished.
When the Dow Jones Industrial Average dropped last week to its lowest level in almost four years,
its price-earnings ratio was 32 percent below a peak reached four months earlier.
The P/E ratio -- a measure of how much investors are paying for each dollar of a company's profit
over the prior four quarters -- has fallen an average of 26 percent during market declines in the
past 100 years, according to Ned Davis Research in Venice, Florida. Dow members including
General Electric Co. and Citigroup Inc. may have fallen enough to lure some investors back into
the market this time, too.
``At the lows of a couple of days ago, stocks were emphatically cheap,'' said Darcy MacLaren,
director of equity research and a money manager at Safeco Asset Management, which oversees
$30 billion in Seattle. MacLaren said last week marked the first time in three years that she had a
positive outlook about stocks.
The Dow dropped as low as 21 times earnings from 31 times in March, when the average's 29
percent rally from its post-Sept. 11 low fizzled. Its P/E is now 24.
General Electric's P/E fell to 28 in March from more than 50 two years ago. The largest company
by market value had a price- earnings ratio of 16 on July 23, when the Dow had its lowest close
this year. Citigroup, the biggest financial-services company, sold for 18 times earnings in March. Its
P/E slid to 8.5 last week.
`Traditional Pattern'
The decline in the Standard & Poor's 500 Index's price- earnings ratio also has exceeded its
bear-market average. The S&P 500's ratio tumbled 54 percent from March 19 through July 23.
The average drop was 31 percent during 25 bear markets since 1929, according to Ned Davis
Research data. The S&P 500's P/E is now 32.
Yesterday, the Dow and S&P 500 both rallied 5.4 percent. The latest surge gave them both 13
percent gains the past four days.
``People thought this would be different, but it's looking more and more like we're following the
traditional pattern'' in valuing stocks, said Chuck Hill, director of research at Thomson First Call,
which tracks Wall Street earnings.
Investors also may be willing to pay more for stocks because earnings are starting to rise again
after falling for five straight quarters, Hill said.
Because a stock represents a claim to a share of a company's profit, an increase in earnings can
justify a higher share price.
With 383 of the S&P 500's companies having reported second- quarter results through yesterday,
earnings are 3.9 percent higher than in the same period a year earlier, according to First Call.
The firm's figures show Wall Street analysts are forecasting 20 percent profit growth during the next
four quarters. If the estimates prove accurate, investors who buy now will share in more profit for
each dollar invested.
Fed Model
A model used by the Federal Reserve to gauge shares' value based on forecast earnings also
suggests that the S&P 500 is underpriced now.
The ``Fed model'' divides 100 by the yield on 10-year Treasury notes to find the fair value for stocks.
With the note yielding 4.53 percent, stocks are reasonably priced at about 22 times expected
earnings for the next year. The Dow and S&P 500 both are valued at about 18 times forecast profits.
While the benchmarks' price-earnings ratios have fallen more than average, there is no guarantee
they won't drop further before a new bull market starts. The Dow's ratio declined 60 percent during
the 1973-1974 bear market.
Ned Davis Research defines a bear market as a 30 percent drop in the Dow after 50 calendar days or
a 13 percent decline after 145 days. There have been 32 bear markets since 1901. Two of the
1930s bear markets were excluded in computing the average decline because Dow companies in
aggregate lost money during the period, yielding no P/E ratio.
Stocks overall still trade for relatively high prices. The S&P 500's P/E of 32 is almost twice the
historical price-earnings ratio of 17, according to Standard & Poor's.
Some investors remain encouraged.
``We could easily get a rally that takes the Dow into the 9000s,'' Safeco's MacLaren said. ``I'm not
arguing for a new big bull market, but you can make a lot of money buying stocks when they're
cheap.''
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