Friday February 5, 6:19 pm Eastern Time
When the Big Correction comes, don't blame earnings
By Pierre Belec
NEW YORK (Reuters) - Stocks may be high priced, but when ''The Big Correction'' happens, shrinking corporate earnings won't be the cause of any spectacular pileup for this fast-moving market.
Corporate profits are lagging for the second consecutive year, with recession in one-third of the world more than offsetting the gain from the still vibrant U.S. economy.
But experts say the sad earnings story will not cause the market to unwind. In fact, lousy earnings have not been the chief cause of bad stock markets for a remarkable 64 years.
Bear markets have been triggered by rising interest rates and inflation.
''Data suggest that for the last 64 years, or since 1934, the market has largely shrugged off earnings drops as temporary dips but has reacted violently to adverse changes in inflation and interest rates,'' said Edward Keon, director of Quantitative Research for Prudential Securities.
Interest rates are indeed powerful financial tools and their ability to influence the stock market was shown last year when the Federal Reserve -- faced with a free-falling stock market -- launched a series of panicky interest-rate cuts to insure that the United States was not dragged down by the economic crisis overseas.
The cuts did the trick, but they also lit a fire under the market, sending stocks to record highs.
This week, Wall Street was on pins and needles, wondering if the interest-rate setting Federal Open Market Committee would change its monetary policy, and start to raise the rates. The central bankers, however, voted to keep rates unchanged -- even as the U.S. economy expanded at the fastest pace in 2-1/2 years, which heightened the risk of inflation.
The impact of interest rates was also felt in 1994, when the Fed sent stocks reeling after it doubled them from 3 percent to 5.75 percent in a preemptive strike against what it saw as the threat of inflation.
The big worry now is that stocks have gone too far.
Analysts say corporate earnings are not increasing as quickly as stock market valuations and investors will have a tough time justifying their expectations of companies' earnings potential, as measured by the forward-looking price/earnings ratio. The P/E, as it is called, is at a record 25 times earnings for the stocks in the Standard & Poor's 500 index.
But some are challenging the way Wall Street gauges P/Es.
Allen Sinai, chief global economist for Primark Decision Economics, said stocks are priced just right.
The problem is that the people who preach that stocks have vaulted beyond reason and should come down to more realistic levels are viewing the market through a rear-view mirror, he said.
''The price/earnings ratios of the '70s and '80s, which averaged out then to about 17 times earnings, have to be tossed out because they're not the measures of comparisons for stocks of the '90s,'' Sinai said.
''In this era of great technological change, great corporate balance sheets and low interest rates, we have to rethink what the P/Es should be,'' he said.
In this new economic world, the P/Es should range between 22 and 26 times earnings, which would put the fair-value of the Dow index between 8,300 and 9,700, according to Sinai's calculations. The Dow was hovering at about 9,280 Friday.
Added Keon, ''It may be perfectly sensible right now for investors to pay 25 times earnings, but this can't keep expanding forever and eventually people will have to rely on actual earnings growth.''
He expects the P/E will continue to increase, leveling off at a high of 29 by the year 2001. After that, it will curve down until it reaches less than half of today's numbers.
The P/E is the price of a stock divided by its earnings per share. For instance, a stock selling at $20 with projected earnings of $2 a share next year will have a forward P/E of 10.
What are the odds that 1999 could be a rocky year for stocks?
''The risk of a huge market drop this year is no greater than it has been historically,'' said Keon said. He put the odds at one in five.
But this is a special year and investors, he said, should stay alert for signs that the economy does not deteriorate and the Year 2000 computer bug does not turn out to be a monster problem.
The tremendous stock market gains may be coming to an end.
''We'll probably have two more good years but starting with 2001 we will see market returns of 10 percent rather than 20 percent, as stock valuations reach their natural limits.''
(Questions or comments can be addressed to Pierre.Belec(at)Reuters.Com)
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