To: Lucretius who wrote (21150 ) 5/2/1998 11:14:00 PM From: Tulvio Durand Read Replies (1) | Respond to
LT, what's gotten into you? Looks like you're wearing the sandwich board that reads "REPENT (sell) -- THE END (crash) IS NEAR".
From what I understand, as long as interest rates remain near the 6% level there will not be any serious market retrenchment, nor will there be an end to the bull.
Here's the case for a continuing bull market (from the Jerry Klein newsletter, last week) whose logic I cannot find fault with. Can you?
Tulvio
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The case for acceptable overvaluation. Here's why the sky-high levels in today's market aren't (yet) a cause for alarm.
by Michael Brush
Despite soaring market levels, like Nasdaq's record 1887 close Monday, it's hard to pick up a paper without reading another article on why sky-high stock valuations should not worry you.
And maybe they shouldn't. After all, if your compass for the last 50 or so years had been standard measures of how pricey stocks are -- things like price to earnings ratio or price to book ratio -- you
would have missed one of the biggest rallies ever. And you would also have jumped into the stockmarket right ahead of one of its most disastrous years.
Salomon Smith Barney strategist John Manley points out that stock
values, based on the price to sales ratio, nearly doubled between 1954 and 1958. Stocks then followed that up by rising for another eight years.
On the other hand, between 1968 and 1973 market valuations were cut in half. But buying on that signal of cheapness in the market would have put you into stocks just before 1974, one of the worst years in recent history for equities.
"The last time the market looked really cheap, it went down for a couple of years," notes Manley. "The last time it looked really expensive, it went up for another four years." Valuation, in other
words, can be a very misleading indicator. "It is not that valuation
does not matter. It is just that it matters two or three times every 25 years. And you don't know when that will be."
Likewise, relatively poor earnings growth -- like that being confirmed by earnings releases now coming in -- is not by itself a reason to run for the exit. (Companies right now are generally beating estimates, but the growth in earnings compared to last year is near zero for the S&P 500.) In the late 1950s, Manley points out, there was a six-year stretch with virtually no S&P 500 earnings growth, but the market was up about 10% a year for each of those years. And between 1976 and 1979, earnings were up about 40%, but the market was down.
So instead of looking at numbers like valuations and earnings in
isolation, the trick is to figure out what caused valuations to go up so high, and then watch for signs of whether that will change. "The big moves in valuation in the last forty or fifty years have been
caused by factors that were persistent or pernicious enough to keep them going for awhile," says Manley.
In the case of the most recent leg of this bull market, the catalyst is obvious: declining real interest rates. And for the moment, they are far from levels that would cause a serious market crash.
When each of the three major market tops of the last 75 years crumbled (in 1929 and 1987 in the U.S., and in 1989 in Japan) rates were up between 25% and 35% from their lows of the previous two years. Currently rates are up around 3% from their two-year lows. "Can anyone show me a bear market that began when rates were still down? It is just not there," says Manley.
This is all just another way of saying that while stocks may look
overvalued compared to their own record, they still look good when compared to competing assets -- like bonds. And Peter Canelo a
market strategist at Morgan Stanley Dean Witter Discover, says this is the valuation measure that counts.
He compares stocks against bonds by using two rulers. One is the spread between the dividend yield on stocks and the yield on bonds. The higher the spread, the more attractive bonds are. Right now,
the spread (comparing the S&P 500 stocks to the 30-year bond) is around 4.4%. That spread has to get over 5.5% for investors to start thinking about getting out of stocks. And by comparison, the spread was up around 7.25% before the 1987 correction. "It is incredible how unattractive the bond market is, or how attractive the stock market is," says Canelo.
He also looks at the difference between the total return for stocks
(their long-term growth plus their yield, or 9.4% at the moment) and bonds (the 30-year bond is paying about 5.9%) At about 3.4% right now, the difference is off the scale that normally ranges from 1 to 3. Stocks, in other words, are a much better deal. "Both of these, the low spread and high premium paid by stocks, are telling you that stocks are about as cheap as they can be," says Canelo.
He thinks that multiples could get even higher with lower inflation or
lower interest rates. Salomon Smith Barney's Manley agrees. "I am scared to death of the valuations and the earnings. But I think the market will do pretty well this year," he says.
"As uncomfortable a feeling as it is buying stocks in this kind of
environment," Manley continues, "you have to recognize that there are times when the market stays fairly highly valued. You have to
look for what made it expensive - low interest rates -- to go away."
