Weekly Wall Street column - What's a fair value for stocks?


  • Business
  • Saturday, 09 Jul 2005

By ELLEN SIMON

NEW YORK (AP) - Are stock prices too high, too low, or right where they should be? 

In the sometimes quarrelsome confines of Wall Street, there's no consensus. 

"Valuation is like beauty - it's in the eye of the beholder,'' said Ed Yardeni, chief investment strategist at Oak Associates. 

Stocks have traded nearly flat for most of the year, reacting mildly after Thursday's terrorist attacks on London, the summer's increasing oil prices and the year's steady march of Federal Reserve interest rate hikes.  

If these events haven't pushed stock prices dramatically higher or lower, an observer could be forgiven for thinking the current prices must be correct. 

But underneath the market's placid surface, there's stubborn disagreement about whether stocks are superb bargains or overblown. 

"Wake up, equity market! I recommend 100 percent stocks,'' Edward Keon, chief investment strategist and director of quantitative research at Prudential Equity Group, wrote in a research report Tuesday, arguing stocks look "very cheap'' compared to bonds. 

Not so, says James Stack, president of InvesTech Research in Whitefish, Mont. "From a historical perspective, stocks are approximately 20 percent overvalued.'' 

Who's right? Who knows. What we see is how investors gauge valuations, deciding whether individual stocks - and the moment's markets - are worth buying or selling. 

Of course, if anyone had a magic model for valuing stocks, there would be no dispute over valuation and no risk in the market. So, we proceed with caution.  

"There have been countless attempts to develop models to determine whether the market is overvalued or undervalued that have been off the mark, sometimes wide off the mark,'' Yardeni said. 

Some investors track the price of stock versus the price of gold, calculating how many ounces of gold you'd need to buy the Dow Jones industrial average.  

(You would need about 23.37 ounces at current values.) 

Or, they compare the price of stocks to the Consumer Price Index. By this measure "we're at the peak of a cycle,'' said Gibbons Burke, editor of Markethistory.com, a financial research Web site. 

"We're looking at a big decline over the next 15 or 20 years. It's not great news, but that's what the chart says.'' 

The standard metric for valuing individual stocks - and markets - is price-to-earnings ratios, or P/Es.  

The problem: Investors disagree on what a fair P/E is. In a report released Tuesday called "Nobody knows anything: Thoughts on equity market valuation,'' Keon wrote, "By now, shouldn't there be more widespread agreement on what constitutes a fair market P/E?'' 

Those who want to buy only when markets are cheapest look for P/Es below 15.7, the historical mean. 

"They love the market when the P/E is 8 to 10,'' Yardeni said. 

"The only problem is, (at that point) the rest of us are unemployed or worried about being unemployed.'' 

Comparing the current P/E ratio for the Standard & Poor's 500, which is about 19.5, to the historical mean P/E is how InvesTech's Stack determined stocks were 20 percent overvalued. 

Stack also watches P/Es in relation to interest rates. Higher valuations tend to be supported by lower interest rates, Stack said. 

"The last two times we saw a single digit P/E for the S&P 500 were 1982 and 1974, both instances where short-term interest rates were 8 percent or higher'' he said.  

When interest rates increase, money market funds and bonds become more attractive. 

"Today's low level of interest rates are providing an important buoyancy to the market and to market valuations,'' he said. 

Another popular model is called the "Fed Model,'' because the research behind it was done by Federal Reserve staff and because believers think it's something Fed Chairman Alan Greenspan considers as he soaks in the tub. 

The Fed Model takes the ratio of stocks' earnings-to-prices, which is their "earnings yield,'' and compares it with the 10-year Treasury bond yield. Under the model, when the earnings yield is higher than the bond yield, stocks are a bargain. 

Fed Model computations were part of the reasoning behind Keon's "100 percent stocks'' report. Keon computes his earnings yield using analysts' projection of earnings. 

When figured this way, the Fed Model is usually bullish on stocks, and Keon's computations are no exception.  

He finds the earnings yield for stocks is around 6.6 percent, while the yield on the 10-year Treasury bill has been hovering around 4 percent. 

"Stocks look as cheap compared to bonds today as they looked expensive in early 2000 at the height of the equity bubble,'' he wrote.  

"Either stock valuation should rise or bond prices should fall or a combination of both, according to the model.'' 

Yardeni said his preferred model is taking 20 and subtracting the yield of 10-year Treasury bills to get the market's preferred P/E. 

Under that model, the P/E of the S&P 500, calculated using last year's earnings, should be roughly 16. 

Instead, it's about 19.5. 

"It hasn't been a perfect model relative to what the stock market has done, but it's been pretty good,'' he said. 

"I can't tell you why it works, but it shows why forecasting is so frustrating. The simple model is as good as any of the sophisticated models I've seen.'' - AP 

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