Don't Worry, Be Bullish

Stocks are high, all right. But this market may well have more room to run

The rip-roaring bull market that has more than doubled the Dow Jones industrial average over the past 2 1/2 years has always had its doubters. Bears have long warned of a sharp decline because stock prices--when measured by standard yardsticks of earnings, dividends, or book value--were as high or higher than they had ever been. No matter. The bull charged ahead. The bears who bailed out a year ago missed some juicy profits: a 51% jump in the Dow Jones industrials and a 49% rise in the Standard & Poor's 500 index.

Now, with the Dow nearing 8100, even bullish investors are taking another look at valuation. They're rerunning their models, incorporating the latest info on stock prices (up), interest rates (down), inflation (benign), and earnings growth (better than expected). Many are concluding stocks are overvalued--at least a bit.

BLISSFUL CONDITIONS. But don't dump your stocks just yet. Forget the grim comparisons to 1987 and or even 1929. Look forward, not backward, and you'll see that an S&P 500 that's selling at a historically heady 23 times the preceding 12 months' earnings maybe isn't out of line. The remarkable state of the U.S. economy is providing all the ingredients for more stock market gains. Growth remains strong, incomes are rising, productivity is improving, earnings are expanding, the budget deficit is shrinking, and inflation is tepid. The technical landscape is also superb for equities: strong demand from mutual funds, corporate investors, and foreign buyers. These blissful conditions may not last forever, but they're the only thing on the radar screen now.

Given these conditions, even many analysts whose models indicate overvaluation aren't alarmed. "We're a long way from the levels of 1987," says Robert E. Butman, a consultant to DAIS Group, a research boutique that caters to institutional investors. By his reckoning, stocks are about 4% overvalued, vs. 16% on Oct. 1, 1987--just a few weeks before the worst one-day plunge in U.S. market history. Peter J. Canelo, an investment strategist for Morgan Stanley, Dean Witter, Discover & Co., estimates the market to be about 12% overvalued. But that comes from looking at the S&P 500, not at the mid-cap and small-cap stocks that still offer more attractive valuations.

The strongest buy signal lately came from Federal Reserve Chairman Alan Greenspan. In his July 22 testimony before Congress, he called the economy's performance "exceptional." Greenspan let it be known that he would raise rates if necessary, but left investors with the impression that no hike was imminent. The Dow logged 155 points to close at 8062 and added 27 points on July 23.

Greenspan never mentioned the "new economy," but, increasingly, investors are sensing that the U.S. economy is changing in fundamental ways. "We're in the seventh year of an economic expansion and inflation is 2% and falling," says John F. Snyder, portfolio manager of the John Hancock Sovereign Investors Fund. "Things really are different. The higher valuations can be justified."

Take the stock of Gillette Co. Brenda Lee Landry, a veteran analyst at Morgan Stanley, Dean Witter, says she has to convince clients that at $101 a share--or 33 times expected 1998 earnings--it is still a buy. But like many venerable manufacturers, once-sleepy Gillette has slimmed down and is now a world-class competitor. Earnings have been growing about 18% a year, and Landry predicts growth of 17% a year for the next five years. "Toss in a 1% dividend, and you can earn 18% a year from steady, reliable Gillette, vs. 6.4% in a bond," says Landry. "Which would you choose?"

If interest rates continue to ease, it's a no-brainer. In a falling rate climate, stocks can pay off even better than bonds. DAIS's forecast, for instance, is based on a long-term interest rate of 6.4%. But if the long bond were to drop to 5.9%, the market would be slightly undervalued, says DAIS's Butman. In the first three weeks of July, long-term interest rates came down about 0.4 percentage points to around 6.4%. And earnings estimates for 1998 are working their way higher.

FORWARD-LOOKING YARDSTICKS. What's the best way to value stocks now? Some long-used yardsticks, like comparing price to historic book value or dividend yields, are not so reliable in today's market. For instance, massive restructurings and write-offs in the early 1990s rendered book value--a company's assets less liabilities--a relatively useless measure. By the same token, companies have channeled cash they once spent on dividends into share repurchases that boost stock prices. So even though dividend yields are low, valuations aren't necessarily out of line.

Many yardsticks are limited because they don't incorporate future expectations--and it's expectations that are driving investors. That's why many pros are focusing on tools such as dividend discount models (DDM) to help determine whether a stock or the market is cheap or dear. DDM works on the principle that an investment is worth the present value of all the future cash it generates. That means forecasting earnings, estimating the percentage of earnings to be paid in dividends, and using a current interest rate to discount all cash back to today's value. If that's more than the stock's current price, it's a buy; if below the price, it's a sell.

That's not the end of it. DAIS Group, for one, takes this further and calculates an expected return for a stock a year from now. Among the most promising: Corporate Express, an office-supply retailer, Corrections Corp. of America, a prison operator, and Ascend Communications, a network equipment maker. The same method spots overvalued stocks. Among DAIS's sell candidates: Champion International, Host Marriott, and blue-chip favorites Procter & Gamble, General Electric, and Coca-Cola.

Most pros use multiple methods to value a stock. Another measure, private market value (PMV), gauges a company's worth by its cash flow and assets. Leveraged-buyout specialists use PMV to find takeover candidates. DAIS uses the technique to find undervalued stocks. It compares a company's stock price to its PMV. The lower the ratio, the more undervalued the stock. Using this screen, the research house added insurers USF&G and Aetna and auto makers Chrysler and General Motors to its list of most attractive stocks.

For investors who have seen their index funds and 401(k) accounts soar, it may look like time to cash out. And there's nothing wrong with taking profits. But the cries of overvaluation have been heard before--as the market moved higher. As long as the economy continues to grow and inflation stays low, the naysayers will be wrong.