BEAR CASE STOCKS NOT CHEAP
It’s fine to forecast big profit gains well into the future, but what if prices fully reflect expected gains?
That’s what many bears think. They cite a widely used gauge of stock value called the price-earnings ratio, or the price of a stock divided by its earnings per share. If a share costs $100 and financial analysts expect the company to earn $5 per share in the coming year, the P/E ratio is 20.
The key here is that low P/Es are considered a better deal. Each dollar you spend on a stock “buys” you many dollars of future earnings. High P/Es buy you fewer future earnings.
The S&P 500 now trades at 15 times what companies in the index are expected to earn over the next 12 months, according to FactSet, a data provider. That is slightly above the 10-year average of 14.1 times.
Stocks are “not cheap,” says Aaron Jett, head of stock research at Bel Air Investment Advisors. “But we’re not in bubble territory.”
The problem is, P/Es are often not reliable gauges of stock value. They are based on just one year’s earnings. Those can surge due to a pickup in the economy or collapse during a slowdown.
Many experts believe a better P/E is a “cyclically adjusted” one, which is championed by Yale economist Robert Shiller. And that is showing that stocks are overpriced.
The “cyclically-adjusted ratio” averages annual earnings of companies over 10 years to remove distortions from surges and drops.
It is currently 26. That’s much lower that it was during the late 1990s dot-com bubble when the ratio peaked at 44. But it’s still very high. Since the end of World War II, and the average is 18.3. Go back a century, and the average is 16.
“Make no mistake—this is an equity bubble, and a highly advanced one,” wrote economist and fund manager John Hussman last month in one of his weekly commentaries to investors.
THOSE COMING RATE HIKES
The Fed may be able to raise rates slowly without damaging the economy and stock markets. But its record isn’t entirely reassuring.
Three of the past five bull markets ended after the Fed increased rates. If the central bank finds itself scrambling to contain inflation and has to raise rates quickly and sharply, stocks could fall 20 percent, the official threshold for the beginning of a bear market.
Inflation doesn’t appear to be a problem right now. The consumer price index is up 2 percent in the past 12 months, roughly equivalent to the Fed’s target. But that could change fast if the economy heats up.
STRUGGLING ECONOMIES ABROAD
U.S. companies rely more than ever on foreign economies remaining healthy. Unfortunately, many of those economies are stumbling.
The 18 countries that share the euro, a region that accounts for nearly a fifth of global output, didn’t grow at all in the last quarter. China, the world’s second-largest economy, is slowing rapidly. And Japan, the third largest, shrank 7 percent compared with a year earlier.
Most economists expect the U.S. to shrug off the troubles abroad and for growth to pick up. But not everyone.
David Levy, an economist who oversees the newsletter “The Levy Forecast,” predicted the last U.S. recession with uncanny precision. He says another one is coming next year. The cause: Downturns elsewhere, not domestic trouble.
Even if he’s wrong and the U.S. continues to grow, slowing economies overseas will make it harder for companies to post higher profits. Companies in the S&P 500 generate nearly half their sales abroad.
(You can reach Bernard Condon on Twitter at https://twitter.com/BernardFCondon .)
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