If you want to know where stocks stand, check the Dow Jones industrial average. But if you want to know what they are worth, you will need to think a little harder.
Maybe it’s time to do just that.
After two decades of spectacular gains, the bull market suddenly seems shaky. Are current stock prices justified? Or are we in the midst of a market bubble?
Nobody can say for sure. Still, it is useful to have some handle on what stocks are worth. Without that sense of value, you could get spooked by market gyrations and end up selling shares at the worst possible time.
By many traditional measures, stocks are ridiculously overvalued. At year-end 1999, the companies in Standard & Poor’s 500-stock index traded at 28.6 times estimated 1999 operating earnings and yielded just 1.15 percent, according to Arnold Kaufman, editor of Standard & Poor’s Outlook, a weekly newsletter.
By contrast, since 1945, the average price-earnings multiple has been 14 and the dividend yield has averaged 4.12 percent. For the S&P 500 to revert to average historical valuations, it would have to plunge between 51 and 72 percent.
But if that were going to happen, it should have happened years ago. Based on these yardsticks, the market has long been overvalued, Kaufman notes. Yet share prices have continued to climb.
So what are these traditional value measures failing to capture? Three key changes have occurred, says William Reichenstein, an investments professor at Baylor University.
First, interest rates have dropped sharply over the past two decades, so that bonds are a less compelling alternative to stocks.
Second, the so-called equity risk premium has declined, as investors become more comfortable holding stocks.
Finally, earnings growth has picked up. The booming economy has meant faster sales growth for companies, while technological changes have bolstered productivity. Indeed, fast-growing technology companies now account for some 30 percent of the S&P 500.
Those three changes “would justify price-earnings multiples being higher,” Reichenstein says. But to justify today’s sky-high multiples, you still need to don rose-colored glasses.
To understand why, compare today’s 6.6 percent yield on 30-year Treasury bonds with the 4.0 percent earnings yield on the S&P 500. Where does that 4.0 percent come from? The analysts at Standard & Poor’s, a division of McGraw-Hill Cos., are forecasting that the S&P 500 index will have operating earnings of $58.27 per share this year. Divide that $58.27 by the S&P 500’s current level, and you get an earnings yield of 4.0 percent.
Why compare this 4.0 percent with the 6.6 percent yield on 30-year Treasurys? Just as bond-holders receive a bond’s yield, so a company’s earnings yield represents the money available to shareholders. In most cases, of course, companies don’t pay out all this money. Instead, they buy back stock and reinvest profits, with an eye to boosting earnings per share.
Historically, bond and earnings yields have tracked each other fairly closely, which seems reasonable. On the one hand, stocks are riskier. On the other hand, earnings should grow.
So how do you justify choosing stocks at 4.0 percent over bonds at 6.6 percent? You need to consider stocks to be almost as safe as bonds and to be confident that companies will deliver healthy earnings growth for many years.
“I don’t think it’s necessarily a one-to-one relationship” between dividend yield and earnings yield, Kaufman says. “In recent years, the earnings yield has typically been below the bond yield. In the case of bonds, the interest is fixed. In the case of stocks, the earnings will be improving. People are banking on considerable growth.”
To get a sense of the size of this bet, consider a model put together by professors Charles Lee and Bhaskaran Swaminathan of Cornell University and James Myers of the University of Washington. Their model calculates the intrinsic value for the Dow industrials, by taking into account Treasury bill rates, forecast profits and the risk premium demanded by investors. Right now, the model suggests that the Dow is some 30 percent above its intrinsic value.
The broad averages, however, may not tell the whole story. Kaufman notes that half of last year’s gain in the S&P 500 can be accounted for by just eight technology stocks. Indeed, 230 of the S&P 500 stocks are below their level of two years ago.
What to do? “If you leave stocks, you’re betting that you know how to value stocks better than everybody else,” Reichenstein says. He isn’t willing to make that sort of all-or-nothing bet.
But Reichenstein isn’t averse to smaller adjustments. “A good rule of thumb is to move plus or minus 10 percentage points from your target stock holding,” he says. “If you usually hold 60 percent in stocks, you might reduce it to 50 percent. Small bets don’t kill you.”
