So They're Overvalued. Now What?

Unless rates come down, stocks will remain vulnerable

Back in December, most economists and investment strategists were betting that the surging U.S. economy would slow in 1999. That would make it tougher for companies to show significant earnings growth and for the stock market to knock off another year of double-digit gains.

Surprise. The economy is far stronger than expected, economists are falling over each other to boost their gross domestic product forecasts, and some investment strategists are even increasing their corporate earnings estimates. "This could be the U.S. economy's strongest year of the decade," says strategist Peter J. Canelo of Morgan Stanley Dean Witter. But that good news has been all but undermined by the bond market, where long-term interest rates have climbed about 0.5 percentage points to 5.70% since the first of the year. With this runup in rates, some fear the stock market has become dangerously overvalued, vulnerable to a steep decline on any bad news.

TECH DAMAGE. Indeed, long-term interest rates are back where they were right before last summer's 20% stock market correction. Worse yet, many on Wall Street expect that the Fed will move toward higher short-term rates later this year. True, considering the higher rates, the damage to the stock market has not been that bad. The Dow Jones industrial average, at 9276, is still up 1% for the year, though it's well below its all-time high of 9643.3 hit on Jan. 8. The Standard & Poor's 500-stock index, down 4.1% from its Jan. 29 high, is flat for the year.

There's been some serious damage, however, in the tech sector. The tech-heavy NASDAQ Composite Index is down nearly 10% from its Feb. 1 high, though it's still up 3.3% so far this year. Many of its stars have tumbled from their recent highs: Dell Computer, down 25%; Intel, down 19%; and Yahoo!, down 26%. The latest casualty is 3Com, which dropped 9% on Mar. 3 after the company projected a fall-off in earnings. It's now down 47% from its high.

Just because the market overall hasn't yet collapsed doesn't mean investors have dodged the bullet. The market's vulnerability lies in its valuation. Consider one widely followed valuation model, used by the Federal Reserve, which compares the interest rate on the ten-year U.S. Treasury bond with the forward price-earnings ratio based on the next 12 months' earnings forecasts. Economist Edward E. Yardeni, who tracks that model for Deutsche Bank Securities Inc., says stocks--with a forward p-e of 24 and an interest rate of 5.32%--were 25% overvalued on Mar. 2 (chart). That compares to 12.4% overvalued at yearend when the yield on the ten-year bond was 4.6%, and 16.4% undervalued on Oct. 9 when the yield was 4.8%. Back then, the S&P 500 index was 20% lower than it is today. The last time the S&P 500 was this overvalued was last July, just before the market began a 20% correction. And Joseph Abbott, equity strategist for I/B/E/S International Inc., says the last time the S&P was overvalued over this long a stretch was in the two months before the 1987 market crash.

TREADING WATER. Is that in the cards now? Not necessarily, as periods of overvaluation can drag on. "People don't sell their stocks just because interest rates are up a half a percent," says Charles Pradilla, chief investment strategist at S.G. Cowen Securities Corp. "But when the market is highly valued, the fallout from glitches in earnings or revenues is exacerbated. When the market's undervalued, the reaction to earnings shortfalls is a one- or two-day event." And of course, the fallout from global financial events such as the Russian debt crisis is more severe in an overvalued market than it would be in one that's cheap.

So They're Overvalued. Now What?

A better outcome for investors than the unspeakable one--a swift collapse in prices--would be faster earnings growth. Indeed, earnings tracker Abbott says estimates have inched up about 1.7% since December. But many think the analysts' forecasts of 16% growth for S&P 500 earnings are already high, and likely face some downward revision as the year goes on. Higher rates, says Stanley A. Nabi, strategist for money manager Wood Struthers & Winthrop, are raising interest expense for companies, while the stronger dollar and continued economic weakness abroad cut the earning power of U.S. multinationals. Add to that pricing pressure and tight labor markets, "and it looks like we're in for another year of sluggish earnings growth," says Nabi. "The market will be treading water at least through the first half."

Perhaps the stock market's best hope for renewed gains lies in a bond market rally. If interest rates fall back to yearend levels, that would go a long way toward restoring the stock market's buoyancy. But if the economy continues to show its muscle, it's going to be difficult for that to happen.

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