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Warning: Ignore the 'Stocks are Cheap' Argument

Thursday, 13 Mar 2008 04:57 PM

Numerous Wall Street "experts" have repeatedly told investors over the past five months that stocks are "cheap" and that individuals should therefore add new money to their investment portfolios.

For example, in early October the S&P 500 Index was trading at around 1,540 and the price-to-earnings ratio (P/E) for this common barometer of stock market activity was around 18.2.

At that time, I heard several investment bankers and mutual fund portfolio managers tell investors that stocks were undervalued and that the pullback in stock prices was a normal "correction."

Stocks trended lower in December and the P/E ratio for the S&P 500 fell to around 17.5, yet those same "experts" told investors that stocks were trading at bargain prices and that individuals should continue to add stock to their portfolios.

Now the S&P 500 has declined more than 16 percent over the past five months and the P/E ratio is around 16.5. Still, many of these self-serving money managers on Wall Street are telling their clients and listeners that stocks are significantly undervalued.

So, what's the stated reasoning behind the "stocks are cheap" argument?

The answer typically given by the Wall Street experts is that stock prices are currently low relative to their expected future earnings — that is, that their P/E ratios are low.

Although P/E ratios have in fact fallen somewhat over the past few months, my research shows me that stock prices have often trended lower for extended periods of time during periods when P/E ratios were declining.

Why? Because P/E ratios tend to fall when investors expect publicly traded companies to soon begin reporting declines in earnings — in the denominator of the P/E ratio.

Guess what? That's exactly what has started to happen. For example, teen clothing chain American Eagle Outfitters announced yesterday morning that its earnings declined 6.4 percent during the fourth quarter of 2007 as the company increased discounts to clear out unsold merchandise.

Earlier in the week, Texas Instruments — the second-biggest U.S. chipmaker — cut its first-quarter earnings forecasts, due to slowing demand for mobile phones, electronics, and industrial products.

This announcement follows a March 4 report from Intel — the world's biggest maker of semiconductors — in which the company said that it had reduced its earnings projections because of falling prices for the chips that store data in cameras and music players.

Numerous other retailers and technology companies also recently reported a decline in their earnings and lowered profit projections for the next two quarters.

For example, Lowe's, the world's second-largest home-improvement retailer, announced last month that its fourth-quarter profit fell due to the worst U.S. housing slump in a quarter century. The company also lowered its full-year earnings forecast for the current fiscal year.

I urge you to ignore the "stocks are cheap" argument, because my research indicates that many more companies will soon report declines in earnings and that they'll likely lower their forecasts for future earnings.

As a result, I expect stock prices to continue to trend lower, as equity prices are ultimately determined by the level and direction of corporate earnings.

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DavidFrazier
Numerous Wall Street "experts" have repeatedly told investors over the past five months that stocks are "cheap" and that individuals should therefore add new money to their investment portfolios. For example, in early October the S&P 500 Index was trading at around 1,540...
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