Up, Up, and Away
Stocks still look inexpensive even as the bull market continues to hit new highs
You can use any number of words to describe this bull market, including old, unpredictable, irrepressible, and record setting. Frothy is not one of them.
Despite a 4
"It's almost unprecedented to see a cheaper market 4
Why are investors convinced that this market is cheap? The most commonly used yardstick to gauge market valuations is the price-earnings ratio. Right now, the P/E ratio for the S&P500 index is about 18, based on earnings for the past four quarters.
By historic standards, this isn't dirt cheap, but it's substantially lower than the market's P/E of 27.1 at the start of this bull market, on Oct. 10, 2002. It also runs counter to history. In the past, bull markets that have survived to their fourth birthdays have typically seen their P/E ratios climb-by about 28 percent on average.
Market strategists and money managers say stocks are now particularly cheap in light of the current state of the economy. For example, in past periods when inflation has run between 2 percent and 3 percent-which is the case today-the S&P500's P/E has averaged 19.7. And when long-term bond yields have been about where they stand today-which is under 5 percent-investors have been willing to pay 22.8 times the S&P's earnings.
Considering all of these factors, "the market is very reasonably priced, to the point of being cheap," says David Kovacs, head of quantitative research at Turner Investment Partners. This is one reason Kovacs thinks equity prices could "accelerate to the upside from here," he says.
Using his own gauge of market valuations, Tobias Levkovich, chief U.S. equity strategist for Citigroup Investment Research, thinks that domestic stocks could be undervalued by as much as 20 percent.
Does that mean the market will soon rise an additional 20 percent? Not necessarily.
New high? Think of it this way. If the S&P 500's current P/E of 18 were to rise even a single point to better mirror its historic average, "it would be worth about 6 or 7 percent on the market," says Jeffrey Kleintop, chief market strategist for LPL Financial Services. This means the S&P 500 index could easily move up an additional 90 to 100 points, which would send the index back above its all-time record high of 1527, set on March 24, 2000.
Here's the even better news: In past periods when the S&P 500 has set new all-time highs, it didn't just stop there. It kept going for months, if not years. Indeed, since 1942, stocks have gained an additional 5.2 percent on average in the six months following the establishment of a new S&P high.
Of course, it's too soon to tell if this bull market will morph into the Energizer Bunny. But market strategists are hopeful that this rally will continue, in large part because of the surprising strength of corporate earnings-which is a big reason why the market's P/E is so low to begin with.
No doubt, corporate profits are slowing. After growing 19 percent in the third quarter of 2006 and 10.6 percent in the fourth, first-quarter earnings for companies in the S&P 500 are expected to rise a more modest 8.5 percent, according to Thomson Financial.
But less than two months ago, Wall Street thought corporate earnings would grow just 3.7 percent. So a growth rate near 9 percent is turning out to be a cause for celebration.
Jack Caffrey, equity strategist for JPMorgan Private Bank, notes that 2 to 3 percentage points of the S&P's earnings gains were attributable to the falling dollar, which increased the value of foreign profits earned by U.S.-based multinationals.
But regardless of the reasons, the fact that corporate profits have risen much faster than expected may explain why investors haven't had time to adjust. The question is: Will investors start to ratchet their expectations higher now that profits have been running so strong?
As long as investors don't get too far ahead of themselves-and barring any unforeseen geopolitical crises-Wall Street thinks this bull may still have room to roam.
This story appears in the May 28, 2007 print edition of U.S. News & World Report.