Is Another Bubble Building?

While share prices seem to be rising too fast given earnings growth, a closer look shows that S&P 500 is likely still undervalued

By Sam Stovall

With stocks surging -- seemingly well ahead of a strong recovery in corporate profits -- is it time to whisper the "b" word again? The S&P 500-stock index gained 26.4% from its March 11, 2003 closing low of 800.23 through the recent high of 1011.66 on June 17. Yet many investors expect second-quarter operating earnings for the S&P 500 to advance by only about 7% on a year-over-year basis.

As a result of this disparity in price advances and earnings gains, many are wondering if investors failed to learn their lesson from the last bull run -- and are once again buying their way into a market bubble.

Most of this concern arises from the price-earnings ratio for the S&P 500 using trailing "as reported," or GAAP (generally accepted accounting principles), earnings. Based on this measure, the S&P 500 appears to be expensive at 29 times trailing earnings when compared with the average p-e of 23 since 1988, and dangerously overvalued vs. the average p-e of only 18 since 1963. (One consolation: Today's p-e of 29 is nowhere near the multiple of 46 reached near the end of the prior bull market.)

Some analysts would say that a p-e on GAAP earnings is misleading. That's because of an accelerated writedown of goodwill that was mandated by an accounting change at the end of 2002, which caused fourth-quarter 2002 earnings for the S&P 500 to plummet to $3 per share from $8.53 in the prior quarter, yet rebound to $11.91 in the first quarter of 2003. As a result, some analysts prefer to look at valuations based on operating results, which weren't affected by the forced goodwill writedown.

S&P 500 p-e ratios
Bull-Mkt. High 15-Yr. Avg. 2003e 2004e
Operating 30 20 19 17
As-Reported 46 23 24 21

Using the table above and focusing on operating earnings, we find that even after the recent price run-up, the S&P 500 is now trading at a discount to its longer-term average operating p-e ratio.

Even on a sector basis, we at S&P find that current valuations, in most cases, are well below their bull-market highs. The table below, which compares the sector tables compiled for S&P's Investment Policy Committee, or IPC, in March, 2000, and July, 2003, shows the p-e ratios on projected 12-month operating earnings for the sectors in the S&P Super 1500 Composite index (S&P's total stock market universe, comprising the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes).

Sector p-e ratios based on projected 12-month operating EPS
July, 2003 March, 2000 % Difference
Consumer Discretionary 20 18 11%
Consumer Staples 19 22 -14%
Energy 15 21 -29%
Financials 13 15 -13%
Health Care 20 26 -23%
Industrials 18 24 -25%
Information Technology 33 55 -40%
Materials 23 15 53%
Telecom. Services 17 27 -37%
Utilities 13 14 -7%
S&P Super 1500 18 26 -31%

Not only do we see that the S&P 1500 is trading at a 31% discount to its bull-market high but we also note that the S&P information-technology sector index is valued at 40% below its bubble peak. In addition, only two of the 1500's 10 sectors -- consumer discretionary and materials -- are now trading above their March, 2000, projected p-e ratios.

In summary, even though stock valuations aren't as attractive today as they were earlier this year, in our view they're clearly nowhere near the extremes seen during the height of the most recent bull market. What's more, applying the 10-year average S&P 500 operating p-e of 20 to S&P analysts' estimated 2003 earnings of $53.24 for the S&P 500, we come up with a yearend value for the index of 1060. That means it still has some upside potential.

And while the index may likely experience periods of consolidation along the way, as investors digest some of their profits, S&P's IPC believes that the massive fiscal and monetary stimulus of late will help spur an economic and earnings recovery, thereby allowing the S&P 500 to close the year at 1030. That would represent a 17% year-over-year price improvement and a 4% advance from current level of approximately 990.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of July 11, 2003.

Industry/Sector Company S&P STARS* Rank
Biotechnology/Health Care Amgen (AMGN ) 5 STARS
Computer Storage & Peripherals/Info. Tech. Storage Technology (STK ) 4 STARS
Consumer Electronics/Consumer Discretionary Harman International (HAR ) Not Ranked
Distributors/Industrials Genuine Parts (GPC ) 1 STAR
Fertilizers & Agricultural Chemicals/Materials IMC Global (IGL ) 3 STARS
Health Care Supplies/Health Care SurModics (SRDX ) 4 STARS
Homebuilding/Consumer Discretionary Lennar (LEN ) 5 STARS
Internet Software & Services/Info. Tech. Yahoo! (YHOO ) 3 STARS
Office Electronics/Info. Tech. Xerox (XRX ) 2 STARS
Reinsurance/Financials Everest Re (RE ) Not Ranked
Wireless Telecom Svcs./Telecom Svcs. Nextel (NXTL ) 5 STARS

* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (strong buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief investment strategist for Standard & Poor's