Stocks: Still Too Expensive?

Falling stocks have one upside for investors: The further stock prices plunge—and U.S. stock indexes are down more than 10% in the past month"the more bargains there are for long-term investors.

That's the theory anyway, but it's being tested by a highly unstable environment.

To spot cheap gems, value investors try to focus on fundamental measures, such as earnings. Thus, the famous price-to-earnings ratio, or p-e, is a common, and simple, measure of how cheap or expensive a stock is.

If earnings hold steady, falling prices should make stocks more attractive to long-term investors. But that's not necessarily true if earnings fall as fast, or faster, than prices do. Many investors worry that such is the case right now, as the financial crisis and recession worries intensify.

Record Profits Next Year?

According to Standard & Poor's, which compiles analysts' earnings estimates, analysts expect earnings for the large-cap benchmark S&P 500 index to be flat in the third quarter but rise quickly in the fourth quarter and keep rising into next year. Analysts are even predicting earnings will hit an all-time high in the second quarter of 2009.

"Earnings expectations are still too high," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors. Analysts seem too optimistic about the U.S. economy, he says.

Another problem for value-seeking investors is that data on p-e ratios can be subjective and contradictory—and seem even more so than usual in the past year. Do you focus on earnings of the past year, which have been disappointing (and thus make stocks look more expensive)? Or, looking ahead, do you focus on the better earnings expected to come down the pike?

Historically Alluring

For the S&P 500, the current p-e for the last four quarters is about 16.7, S&P says. But based on analysts' hopes for the next four quarters, the forward p-e is a much more attractive 11.2.

By historic standards, both numbers are fairly attractive p-e ratios. The average trailing p-e ratio in the past 10 years is 21.2, and the average for the past 20 years is 19.3.

But those numbers rely on operating earnings, which excludes unusual items that can hurt corporate bottom lines. Estimates of operating earnings often exclude such major charges as layoffs and investment losses of the sort that have pummeled the financial sector in the past year.

Looking at total earnings instead, the p-e for the past year is now 22.5, while, based on S&P's total earnings estimate for next year, the forward p-e is 19.81. Using this same measure, the historical average p-e for the past 10 years is 25.98 and for the past 20 years is 22.63.

September Quarter Holds a Clue

Brian Gendreau, strategist at ING Investment Management (ING), says there is a strong argument that, after recent declines, stock valuations are at attractive levels. "But that looks attractive only if earnings don't fall out of bed," he says.

The third-quarter earnings season could be a key test. Alcoa (AA), traditionally the first major stock to release its quarterly numbers, is expected to announce results Oct. 7. If earnings for the September quarter hold up well, that could lift the stock market, Gendreau says.

But in response to the market frenzy of the past month, many analysts and investors have become increasingly pessimistic. Bruce Bittles, chief investment strategist at R.W. Baird, believes the earnings season will prompt analysts to start lowering profit expectations. "Expectations have got to come down," he says.

But the Credit Crunch...

Standard & Poor's index analyst Howard Silverblatt agrees, noting that fears of a full-blown recession have returned to Wall Street in recent weeks. The cost of layoffs, as well as rising commodity costs, will likely hurt corporate earnings.

Analysts are already expecting the financial crisis to do plenty of damage. According to S&P, third-quarter earnings for the S&P 500 financial sector are expected to decline 52.4% from a year ago. That's bad, but much better than the huge losses of the previous three quarters, when declines exceeded 100%. In the fourth quarter, analysts are expecting financial earnings to rebound 200% from the huge losses of late 2007.

The rocky condition of the credit markets in the past few weeks, however, raises worries that these estimates are far too optimistic.

...Could Hammer Profits

Credit market troubles may have a broad impact on earnings, warns Brian Reynolds, chief market strategist at WJB Capital Group . The crisis boosts companies' costs of raising capital, which in turn hurts profits. And, Reynolds says, those same troubles also hurt customers, causing sales to fall.

The media firestorm around the economy could also further undermine consumer confidence. "Retailers were already bracing for a difficult holiday," Yoshikami says.

In an environment as unstable and unpredictable as this one, analysts say, p-e ratios and other fundamental measures are only so helpful. Judging whether stocks are cheap or expensive is very much a subjective undertaking, determined mostly by whether you think things are about to get better or get even worse.

S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies.

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