April 30, 2006
Fundamentally
Back to Basics: Are Stocks Too Cheap, or Too Expensive?
By PAUL J. LIM
IN recent years, investors have been picking stocks based on a host of variables, from oil prices to interest rates to earnings growth. But one factor that hasn't played a significant role in the investment calculus lately is valuations.
In other words, investors haven't been paying much attention to how expensive or cheap the stock market is.
You can chalk that up to several factors. For starters, interest rates have remained reasonably low in recent years, despite the Federal Reserve's recent efforts to raise short-term rates. And low market rates "tend to support higher-than-average valuations," said James B. Stack, editor of InvesTech Market Analyst, a newsletter published in Whitefish, Mont.
Moreover, for the last several quarters, corporate profits have been growing much faster than expected. And when profits grow faster than stocks rise, the market actually becomes cheaper, even though share prices are climbing.
But now that corporate profit growth is slowing and long-term bond yields are beginning to rise — the yield on 10-year Treasury notes recently hit 5 percent for the first time in nearly four years — "valuations are going to matter again," said Jeffrey N. Kleintop, the chief investment strategist at PNC Wealth Management in Philadelphia.
To be sure, not many professional investors or analysts think that stocks are expensive right now. Consider the price-to-earnings ratio of the Standard & Poor's 500-stock index. The P/E ratio is the most widely used method of valuing stocks; for the S.& P., the ratio has fallen to 18 from more than 28 in the summer of 2003, according to Ned Davis Research.
"From the standpoint of valuations, things look pretty good," said Sam Stovall, chief investment strategist at Standard & Poor's.
Stocks also continue to look cheap relative to bonds, based on the so-called earnings yield. To calculate the market's earnings yield, take the inverse of the price-to-earnings ratio. In this case, the S.& P.'s earnings yield would be 1 divided by 18, which works out to 5.6 percent. Because 10-year Treasuries are still yielding less than that, stocks are said to be the better buy, according to many market watchers.
But the problem isn't that the market's P/E ratio is too high. It's that the market may push that ratio even lower in coming months.
If enough investors fear rising interest rates, for example, they may decide that stocks are too expensive, even at today's relatively modest ratios. That would drive down equities, reducing the price in the price-to-earnings equation.
"The main determinant of the P/E ratio will be interest rates," said Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago. With rates rising, he added, those ratios are unlikely to rise, because higher interest rates tend to slow corporate profit growth while making higher-yielding bonds a more attractive alternative to equities. History shows that P/E multiples fall significantly during periods of rising long-term bond yields.
Ned Davis Research recently studied this relationship going back to 1954, looking at periods when 10-year Treasury yields have risen. At the beginning of such periods, the S.& P. 500's price-to-earnings ratio was 18.1, on average. At the end of those periods, the average was 14.2. Conversely, P/E ratios tend to rise — noticeably so — during stretches when 10-year Treasury yields fall.
Equally important is why long-term interest rates are rising. If they're climbing because of growing inflationary pressures — and the recent report on consumer prices showed a bigger-than-expected jump in core retail inflation — this could be even worse for equities because there is an inverse relationship between stock market valuations and inflation.
Liz Ann Sonders, the chief investment strategist at Charles Schwab & Company, recently studied market valuations in various inflation climates. When inflation has been running at an annual pace of less than 2 percent, Ms. Sonders found, the average price-to-earnings ratio for the S.& P. 500 has been 23.4, dating back to 1960.
But when inflation climbs to 3 to 4 percent, the average ratio falls to 17.6. And when inflation jumps to 4 to 5 percent, the ratio drops to 14.8, on average.
"One of the reasons why the market has had a tough time making its way out of this trading range is the uncertainty surrounding interest rates and inflation," Ms. Sonders said.
Not everyone thinks that price-to-earnings ratios are likely to decline. Mr. Kleintop at PNC, for example, said that there was a decent chance that those ratios could rise modestly so long as the economy continued to grow at a healthy pace. But whether the ratios rise or fall, he added, investors need to be mindful of valuations.
Mr. Kleintop says he believes that health care and technology are among the sectors that are likely to perform best in the current environment, because their P/E ratios have already fallen significantly. The average ratio for the information technology sector of the S.& P. 500, for example, fell to 22 last year from more than 40 in 2003.
Of course, picking stocks based solely on valuations doesn't always work. Many market strategists point out that even if a stock's price-to-earnings ratio is low, it can always drop further. But while valuations may not be a "valid timing tool for investors," Mr. Stack said, they can still be used to reduce risk in one's portfolio.
Ms. Sonders agreed. She suggested that investors shy away from equities that are trading at higher valuations relative to their historical norms — as they have the most room to decline if price-to-earnings ratios fall. She said that these would include utilities stocks. The P/E for that industry's stocks in the S.& P. 500 climbed to 16.4 last year from 13.5 in 2003.
Investors may also want to take some profits off the table for their small-capitalization stocks, whose P/E ratios have had similar climbs. The Russell 2000 index of small stocks, which has outperformed the shares of many large, blue-chip companies for more than five years, is trading at a price-to-earnings ratio of 27.7, well above the average of 22.6 going back to December 1978.
Small-cap value stocks have enjoyed even greater P/E expansion in recent years. The Russell 2000 Value index, for example, currently trades at a multiple of 23.2, versus its historical multiple of 18.1.
STUDYING market valuations "isn't going to tell you how to generate fantastic returns," said Stephen P. Wood, portfolio strategist at the Russell Investment Group in Tacoma, Wash. "But it will point out places in the market where you can avoid outsized losses," he added.
"In my experience observing investor behavior," he said, "avoiding large losses is one of the main engines that drives long-term performance."
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com. |
