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Hello list,
article on valuation models.
Article Title: "Stocks Still Too Pricey? Two Years Into A Bear, P-Es Say Yes
To Some "
Author: CRAIG SHAW
Section: Business & The Economy
Date: 7/24/2002
More than two years into the worst bear market most investors ever lived
through, you'd think stocks would at least be cheap.
Some say they are, others say not. It all depends on whether you look ahead
or behind.
The standard measure of stock value, the price-earnings ratio, shows the S&P
500 index is pricier than it was at the peak of the tech bubble.
But a different model that looks at interest rates and expected earnings says
stocks are as cheap as they've been in 20 years.
The difference isn't academic. Rattled investors won't jump back into the
market until they think stocks are a bargain. That means the 28-month downturn
could grind on a lot longer.
"If the bear market is to bottom, it would be the first I know about where
the bottom occurred with less than good values," said Marsh Douthat, president
of Atlanta-based Financial/Market Management, a money manager and newsletter
firm that runs $110 million.
The overvaluation camp argues the tech bubble inflated stock prices so high
that they're still not cheap even after the worst decline in half a century.
The price-earnings ratio supports that. P-E measures how much an investor
pays for each dollar a company earns. Value investors often consider a low P-E
the mark of a buying opportunity.
Prices Still High
The S&P 500's trailing P-E hit 40.07 at the end of June, near its record
year-end close of 46.49 for 2001. It's calculated using earnings from the past
12 months. Its 25-year average is 17.8, less than half its current value.
"We want valuations to be much more conservative," Richard Bernstein, chief
market strategist for Merrill Lynch, said Monday on public television's
"Nightly Business Report."
Another stock valuation model - used by the Federal Reserve - tells a
different story.
The model compares the price of the S&P 500 to its 12-month expected earnings
divided into the 10-year Treasury bond yield. Thus, it looks at future
earnings instead of past results and brings interest rates - now at a 40-year
low - into the picture.
This model shows the market fairly valued in December 1996, when Fed Chairman
Alan Greenspan made his famous "irrational exuberance" speech.
Valuations skyrocketed in 1999 and 2000, but now have sunk to their lowest
levels since the early 1980s. After the S&P lost 22.15 to 797.70 on Tuesday,
it was 37.5% under its fair value.
"The indicators don't get any better than this," Don Hays, president of Hays
Advisory Group, said in a July 19 market commentary.
Undervalued markets are corrected by rising yields, lower earnings
expectations, higher stock prices or a combination of these.
Ed Yardeni, chief investment strategist at Prudential Securities, said the
Fed model showed stocks were undervalued from 1979 to 1982, in the late 1980s,
in the mid-1990s and in September and October 1998. Strong rallies followed
each period.
Douthat argues the Fed model leads to a "false sense of security" for those
who follow it. The trailing P-E ratio remains sky-high because earnings have
fallen even faster than stock prices.
"It's simply laughable to call the stock market undervalued today with the
S&P 500 selling at 40 times earnings," Douthat said. "I don't care what
interest rates are."
Other money managers maintain stocks are a bargain no matter what the
trailing P-E ratio says.
"It's just not meaningful," said John Tobey, chief investment officer for
Vantagepoint Funds. "The only way to look at growth is to look at the future."
Tobey argues growth stocks are at their best relative prices in a decade
after being driven down by the recession and accounting scandals. Shares are
now changing hands to stronger holders in a final washout and could deliver
returns similar to the 1988-91 run-up, he said.
"The baby has gone out with the bathwater," Tobey said. "As all the bad
stocks have come down, so have the good ones, especially in the last couple of
months."
The Sept. 11 Effect
Richard Cripps, chief market strategist for Legg Mason, says the trailing P-E
ratio is inflated by recession charge-offs and unusual costs related to the
Sept. 11 terrorist attack. "It reflects an extraordinary period," he said.
"On a forward operating-earnings basis, with the inflation and interest rate
assumptions we have now, the market is fairly valued," Cripps said.
The high P-E isn't why stocks are falling, Cripps says. He attributes the
downturn to "a crisis of confidence" keeping buyers out.
The median P-E ratio for the Value Line 1700 stock index, now at 17, shows
more reasonable valuations than the S&P, Douthat said. But it usually falls to
12 before a major bear market ends, he says.
Douthat agrees investor sentiment traced similar peaks and troughs.
"Investors went from 'Why doesn't everyone own common stocks?' to 'Don't ever
talk to me about common stocks,' " he said.
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