Tags: Bulls | Wrong | Stocks | Cheap

Bulls Have It All Wrong, Stocks Only Look Cheap, Fortune.com Warns

Tuesday, 07 February 2012 01:13 PM

Bulls say stocks are a good deal because surging earnings make price-to-earnings ratios low by historical standards. "A close study of the numbers shows they are wrong," writes Shawn Tully, senior editor at large for Fortune magazine.

Bulls point out that the S&P P/E ratio, based on profits over the last 12 months, is 13.6, far below the average of 18 over the last 23 years. On the face of it, earnings are up and P/E ratios are historically low. Yet stocks only look cheap, according to Tully. (The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. The P/E ratio can therefore be calculated aggregately by dividing the company's market capitalization by its total annual earnings.)

However, the current P/E ratio is a poor measure of stock values because it is extremely erratic, Tully argues. They may signal the wrong time to buy. For instance, large earnings made them look good in 2006 just before financial meltdown, while low profits made them look expensive in 1991 before a long rise in stock values.

Current profits will probably fall, or least stop growing, he predicts. For one thing, margins, the percentage of sales that fall to the bottom line, was 8.9 percent for 2011, far above the average of 6.25 percent since 2000.

Return-on-equity, or profits per sale to book value per share, was about 15 percent last year, compared to the 11 percent average since 1991.

Also profits per share of GDP are unusually high, which may foreshadow a drop in stock values.

Bulls say stock prices must go up because they are so low compared to earnings. It's more likely that earnings will fall, or remain flat, Tully says, arguing that profits usually peak at this stage of the business cycle.

Companies, having benefited from low interest rates and lean workforces, have little left to cut, and will have to hire more workers which will shrink margins.

Reported earnings, not operating earnings, are a more realistic gauge of stock values, he says.

According to MarketWatch, most forecasters predict stocks will be flat this year, constrained by weak corporate earnings and political uncertainty.

Forecasters are sticking to their predictions even though stock markets began 2012 with a rally.

A survey by Birinyi Associates says the average prediction calls for the S&P 500 to end the year at 1349, MarketWatch reports.

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Tuesday, 07 February 2012 01:13 PM
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