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Key Gauge Says Stocks Are Dirt Cheap Now

Sunday, 29 Aug 2010 07:11 PM

 

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With the market down three weeks in a row, investors are understandably grim. But there is a silver lining: Stocks are looking almost as cheap as last year when prices hit 12-year lows — at least according to Wall Street analysts.

It was easy to miss the development amid news of falling home sales, a drooping dollar and sluggish orders for big-ticket goods. But stocks in the Standard & Poor's 500 index now trade at just 11.7 times analyst estimates of operating earnings for the coming year. That is one of the lowest — read cheapest — levels for this key figure.

In fact, this so-called price-earnings multiple is roughly back where it stood at the end of March 2009 just as the market was starting an 80 percent surge.

A lot of investors are kicking themselves for having missed that run-up. The question now: Should they jump in now to not to miss another?

Though it's a rough measure of a stock's value, the earnings multiple holds a certain logic. Before buying the corner pizzeria, you would want to know how many years it would take selling pies and sodas to earn your money back. You can do that by dividing the price you'd have to pay for the business by the profit it generates over a year.

So too with stocks. The earnings multiple divides stock prices by annual earnings to tell you, in a sense, the number of years it might take to be made whole on your investment. The nearly 12 years that analysts say it would take if you bought stocks now compares with an average of maybe 15 over the past two decades.

But the faster clip assumes actual profits won't fall short of the projected ones, and some longtime market observers are worried about that.

"Some analysts are projecting earnings will hit an all-time high in a year," says Howard Silverblatt, senior index analyst at Standard & Poor's. "That would be nice but I wouldn't bet on it."

History suggests he's right to be skeptical.

An April study by McKinsey & Co. of analyst projections over 25 years showed they are almost always too optimistic. On average, analysts estimated that profits would grow at 10 percent to 12 percent annually — almost twice as much as they actually did.

The two periods when analysts lowballed profit growth were in the early '90s and early '00s when the U.S. was coming out of recession as it is today.

Mason Hawkins, CEO of Southeastern Asset Management, has trounced the market by buying stocks when others are selling, and he's been buying lately. His flagship Longleaf Partners Fund returned 4.9 percent annually in the past ten years versus a 1.6 percent decline in the S&P 500.

To get a sense of whether stocks are cheap, the 62-year-old Hawkins looks at how much of your investment you get back in earnings in a year. Based on analyst estimates, if you bought every Dow stock at Friday's 10,150.65 close, you'd get 11 percent back. Though you're not actually pocketing any cash, that's still a big return. After all, some relatively safe investment-grade corporate bonds are throwing off annual interest of 5.3 percent what you pay for them now. That means you'd get nearly six extra percentage points by holding stocks. Since 1932, the difference in yields between bonds and stocks following big drops in the stock market has been 2.8 percent, Hawkins says.

Translation: You're getting rewarded for the extra risk of investing in stocks.

The catch is that the analysts may be wrong. Despite the onslaught of negative economic news this summer, they have barely reduced their estimates. The current forecast for the S&P 500 is an increase of 46 percent this year, then 14 percent on top of that in 2011. Such jumps would mean profits rising above their all-time high in 2006 during the boom.

Not surprisingly, analysts are equally bullish on individual stocks. There are 9,936 analyst recommendations on stocks in the S&P. More than half, or 5,277, are recommendations to buy the stocks, according to Thomson Reuters.

There are just 508 recommendations to sell.

Of course, you can forget what analysts say and compare stock prices to what companies have actually earned.

A widely respected measure, championed by Yale economist Robert Shiller, is a cyclically adjusted earnings multiple. This multiple recognizes that any one year's earnings may be higher or lower than usual because of the economy, and so it averages them over ten years.

Alas, this paints a darker picture. S&P 500 stocks are trading at 20 times cyclical earnings versus an average 16 going back a century. To get to that average, stocks would have fall another 15 percent.

© Copyright 2014 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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