Are Stock Prices Getting Ahead of Fundamentals?

We all want to buy low and sell high.  We also abhor doing the opposite.  How, then, shall we proceed?

Stocks prices, as measured by the S&P 500, are up 50% since April 2009.  The economy has been growing too, but at a tepid 2.5% or so rate, so it is natural to wonder whether stock prices are getting ahead of their true value.  To be able to answer this question, we need an objective indicator of valuation.  If the indicator implies that prices are overvalued, then one should sell or reduce one’s position—while keeping in mind that one can never be certain of true value until after the fact.  If the indicator suggests that prices are undervalued, it might be time to buy.

What is a good indicator of the true value of stock prices?  There are dozens, maybe hundreds of them, all the way from the crazy—the Superbowl theory—to the reasonable—dividend yields.  There is, however, a consensus that one valuation indicator may be the best of them all, and that is the price earnings ratio (PE).  It is obtained by dividing the market value of a stock by its earnings per share.  For example, suppose stock A is selling for $30, and its current earnings per share is $2.  The PE ratio of A would be 15 times ($30 divided by $2).  How do you use this ratio to determine value?  You compare it to others of similar companies.  For example, let’s suppose that similar companies have a PE ratio of 12, whereas A’s ratio is 15 times.  This discrepancy may be a strong indicator that A’s stock price is overvalued.

Where’s the PE ratio now, for the market as a whole, and what is it implying?  Professor Robert Shiller, from Yale University, has an outstanding database that contains up to date PE ratio data on the S&P 500 going back over 100 years.  He updates this information on a monthly basis, and you can download it for FREE.  Go to http://www.econ.yale.edu/~shiller/, and you will find his fascinating numbers.  His data indicates that the PE ratio now is at 26 times the S&P 500 earnings. That’s slightly above the average of the last 10 years, so you might be tempted to conclude that stocks are not overpriced.  However, a PE of 26 is way over the historical 100 year average of 16, which would suggest that stock prices are indeed overvalued at this time.

So, should you sell or buy?

Many factors affect the PE ratio but the two most important ones are a company’s expected future earnings and projected interest rates.  Both these variables deal with expectations.  If the market expects earnings to increase, stock prices will increase.  However, interest rates and PE ratios are negatively related.  This means that, if the market expects interest rates to rise, you can expect stock prices to fall.

The current stock market is nervous about valuations.  The best evidence we have of this is what happened last week to two companies who reported growing sales and earnings, yet their stock prices got slammed big time.  For example, Broadcom reported on April 26 that sales were UP 24% compared to a year ago, and net income was up 9% compared to the same period one year ago.  You would expect, given this great news, the stock price should increase.  In reality, it dropped 15% over three days.  Crazy!  What happened?  Whereas we can’t say for sure why the drop occurred, we can speculate that it was due to the fact that their reported sales and profits were below EXPECTATIONS.  The market is not rewarding results which are below expectations, and this may be a strong signal that the market is getting ahead of itself.

Here’s another puzzling news item.  Caterpillar announced Friday that their first quarter profit soared more than 500% AND raised its outlook for the year, due to growing demand for mining and construction equipment.  Given this wonderful news, you would expect its stock price to soar.  It only rose 2.4%.  Ugh.

In sum, are stock prices ahead of their fundamentals?  As I have explained, that depends on what will happen to corporate profits and to interest rates in the near future, and how these perform versus expectations.  There are indications, however, that stock prices may have reached a temporary ceiling, and that a drop, or a correction, may be in store. 

I would like to hear from you.  First, what do you think will happen to corporate profits in the near future, and why?  If you can answer that correctly, you already know whether you should buy or sell stocks now.  Second, what will happen to interest rates and why?  If you believe they will increase, it might be time to sell stocks.

What do you think will happen?  I would appreciate your feedback.

And by the way . . . If you have a friend who is about to retire, or is retired, I may be able to help them.  I have designed a comprehensive approach designed to help retirees maintain their lifestyle and financial security throughout retirement.  Ask them to call me at 714-771-6000 or send me an email to professor@ulivi.com. I will be happy to offer them a free appointment to explain how my services can help them reach their goals.