Briefing.com's take on valuations...
MARKET VALUATIONS. The Dow and S&P 500 hit record highs yesterday. The rally has been fueled by the lowering of short-term interest rates by the Federal Reserve Board, and not by any current growth in profits. As a result, the traditional measure of value in the market - the price/earnings (P/E) multiple has also hit record levels. Aggregating the profits for the Dow Jones and the S&P 500 in the same manner as the indices are compiled allows for an aggregate P/E to be computed. For the S&P 500 the P/E has now hit 30.2. For the Dow Jones Industrials, which typically carries a lower P/E due to the more traditional and less growth oriented nature of those 30 business, the figure is 25.9. These are extremely high compared to historical norms. Up through 1990, the long-term P/E on the S&P 500 was a little over 14. A rule of thumb was generally that the market should carry a P/E of 20 less the rate of inflation. The Dow has traditionally carried a P/E of several points less than the S&P 500. Of course, when strong profit growth is expected, a lower P/E is warranted. Right now, the optimism in the market is associated with the belief that profits will rise sharply in 1999. For example, both S&P and Dow profits are expected to grow about 17% next year. There are two ways to look at this. One is that because operating profits fell in the third quarter, and have been decelerating since the fourth quarter, that comparisons going forward are easier. The other is that as-reported profits (true profits not taking out one-time gains and losses) have fallen four straight quarters, so regaining profit momentum won't be easy. Wall Street always overestimates profit growth a year out, and Briefing.com believes that profits will grow substantially less that 17% next year. By traditional valuation methods, even with short-term rates at a low 4 1/2% and inflation at maybe 2%, that leaves stocks highly overvalued. But then, traditional valuations have nothing to do with the price of Amazon.com either, so maybe the market can keep going higher. In order for the indices to keep marching forward over a longer period, however, some degree of significant profit growth is required. Otherwise, the now record valuation multiples will be unsustainable. |
