P E's Aren't As Loony As They Look
Worried about the sky-high stock market? For years, investors who sweated about that could look to the market's price-earnings ratio and take at least some comfort. Through last year, even as p-e ratios climbed, they were still below the old high of 23 hit in the early 1990s. But in 1998, prices accelerated far faster than earnings. Now, the market's p-e, 26.7 for the Standard & Poor's 500-stock index, sits at a level that, to many, defies logic.
But don't head for the hills just yet. Those p-e's didn't climb to Himalayan heights on mindless speculation. Stock-price multiples are high for good reason: Over the past three years, reported earnings have grown by more than 50%; long-term interest rates have fallen from nearly 8% to less than 6%, even as gross domestic product expanded; and inflation has dropped from 3.3% to 1.4%.
"Sure, p-e's look high by historical standards," says Richard Bernstein, chief quantitative strategist at Merrill Lynch & Co. "But how many times in the market's history have you had a combination of GDP growth in excess of 4% and inflation under 1.5%?"
HALCYON DAYS. Not many. The years 1961-64 fit the bill, and during that period, the average p-e for the S&P 500 was 19. But in the early 1960s, economically sensitive manufacturing and natural resource companies loomed large in the market. Today's market is dominated by technology, consumer-product, and service companies with less dependence on the economic cycle and more predictable earnings. In addition, the economy--now in its eighth year of expansion--is proving to be far less volatile itself.
Given these almost ideal economic conditions, what is the appropriate p-e for the stock market? That's one of the thorniest questions in investing. Market watchers don't even agree on what number should be plugged into the p-e's denominator. Most of the time, the oft quoted p-e's are based on the past 12 months' earnings. That's a firm number that investors can find in the stock tables every day. But A. Marshall Acuff Jr., equity strategist at Salomon Smith Barney, says it's useless. "Investors look ahead, not back," says Acuff. "Why use a historical number?"
Factoring in projected earnings, the S&P looks a bit more attractive: a p-e of 21.7, according to First Call Corp. But p-e's based on projected earnings are usually lower than those based on trailing earnings, because analysts usually predict profits will go up. The forward p-e is up from 17.1 a year ago, a 27% move, but that's still less than 39% gain in stock prices. How does a 21.7 p-e based on forecast earnings compare with the early 1960s and other periods of high stock valuation? "We just don't know," says Stanley Levine, director of quantitative research at First Call. "Wall Street didn't even start collecting earnings estimates until the early 1970s."
Still, any way you slice it, a p-e of 22 on forward earnings is a big number. And it's most troubling for market veterans who struggle to grasp the idea that the economy is in a new era of high market valuation. "I have over 40 years of investing experience, and it has been a handicap right now," says Robert H. Stovall of Stovall/Twenty-First Advisers. "I looked at p-e's and thought they were high, but 32-year-old managers don't have that problem. They keep on buying, and so far, they've been right."
Stovall thinks high p-e's can be justified for many of the brand-name stocks that have high-quality products and global distribution--such as Coca-Cola, Gillette, and Microsoft--in an era of low interest rates and slow global economic growth. He continues to hold such stocks but is putting new money to work in less glamorous companies such as Chiquita Brands International Inc. and Midway Airlines Corp.
EXPONENTIAL. Edward M. Kerschner, PaineWebber Inc.'s chief investment strategist, argues that many investors have underestimated the power of the bull market because they haven't properly gauged the impact of lower interest rates and lower inflation. Kerschner says the fair value of equities increases at an accelerating rate as inflation falls. Consider a company with a 15% earnings-growth rate when inflation is 5%. Kerschner says its p-e should be about 15. Cut the inflation rate to 3%, and the p-e for that 15% earnings growth rate doubles to 30. Cut inflation another point, to 2%, and the fair p-e jumps to more than 60. Says Kerschner: "Just as with a bond, when you lower the rate at which you discount the earnings, the value increases exponentially."
Another market veteran, Kenneth Safian of Safian Investment Research, doesn't think the S&P gives a good picture of the market. Instead, Safian uses an average of 30 large growth stocks and adjusts p-e's for debt. His reading: The p-e is now 39, compared with 35-36 at other market peaks. Still, he says, interest rates are low enough to allow p-e to notch up to the low 40s before the market is dangerously overvalued.
There's some evidence, too, that the lightning-like runup of large-cap growth stocks is distorting p-e's for the market as a whole and that the average investor's portfolio has a more reasonable multiple. Martin M. Hertzberg, director of research at DAIS Group, says if you calculate the p-e's of the S&P 500 companies equally instead of weighting them by the market value of the companies, the p-e ratio is more modest--just 21.6, nearly 19% lower than the current 26.7. "The General Electrics and Microsofts are drowning everything else," says Hertzberg. That suggests that while the S&P 500 has a high valuation, most portfolios, which are equal-weighted rather than capitalization-weighted, are more reasonably priced.
SQUASHED THUMBS. In considering the p-e question, the biggest trap that investors can fall into is to rely on age-old rules of thumb that once worked but no longer hold up. The dividend-yield rule--sell when the market yield drops below 3%--would have sidelined investors six years ago. The price-to-book-value yardstick broke when the composition of the market changed from asset-intensive manufacturing to asset-light but knowledge-intensive service and marketing companies.
With this in mind, says Kerschner, it's a foolish rule to assume, just because the long-term average p-e is 15, that p-e's must return to that average. "My average age is 23, but I'm never going to be 23 again," laughs Kerschner. "That `reversion to the mean' thinking is a naive assumption. That was what investors did when they didn't have any better way to analyze the market, so you'd assume the average. With the computers and information we have today, you don't need to do that."
Merrill's Bernstein looks at the stock market's p-e through many models, and, he admits, right now the answers are a mixed bag. "The market's high," he says, "but not apocalyptically overpriced as it was in 1987." Back then, interest rates were moving toward 10%. He says perhaps the most prophetic numbers come from the audiences of investors he meets. "I always ask how high they think inflation is, and they usually come in at 2.5% to 3%," he adds. "The real number is half of that."
That, says Bernstein, means inflationary expectations are far too high. "A resurgence of inflation could kill the p-e's, but where is it going to come from?" he asks. And a recession would also deflate the p-e's, yet that seems just as unlikely, given the current economic scene. So p-e ratios, high as they are, still seem justifiable--and who knows, they may even have room to expand.