Valuations Will Determine Where Stocks Go Now

Why is everyone so gloomy? The New Economy is alive and kicking, judging by the way investors are valuing the stock market.

Stocks soared to sky-high valuations over the past five years as investors bet that a stable, liberalized economy, combined with a technological revolution, was ushering in an era of superior profits growth. And despite the bad vibes in the market, the S&P 500 index, which tracks large-capitalization stocks, says that scenario is still a distinct possibility.

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And it's giving such a bullish prognosis even after skidding 25% from its 52-week high of 1534 into bear market territory.

But there's a problem: Figures show that the New Era never existed and, what's more, there is little chance of a sizable profits recovery in the next three years. That spells one nasty scenario: Stocks have further to fall, as investors slowly wake up to the fact that they're holding tin, not gold. In fact, the S&P 500 needs to drop to between 800 and 1000, or as much as 30% from currents levels, for the index to lie within its average historical valuation range.

Assuming

The closely watched yardstick closed at 1160 Friday. Forecast 2001 operating earnings for the index are $57, marginally above 2000's $56.50, according to Thomson Financial/First Call. For 2002, S&P 500 companies are expected to earn $63.22. That works out at 12% earnings growth in the two years to the end of 2002, or an average of 6% a year.

New Era? Earnings data* suggest otherwise

*S&P 500 earnings growth, three-year average. Source: Detox

How much are investors currently paying for those earnings and that growth? The price-to-earnings ratio is 20 using the 2001 forecast earnings, and 18 for the 2002. As you can see, those P/Es are about three times the expected growth rate of 6%.

But how do those numbers compare with historical averages? Since 1980, which is often cited as the starting year of the bull market, the average earnings growth rate for the index has been 8% and its P/E 16, giving a price-to-growth ratio of 2 (16 divided by 8). If the S&P 500 were to trade at 16 times 2002 earnings, it'd be just north of 1000. But if it were to trade at 12 times those profits (twice the expected growth in 2000-2002), it'd be at 760.

Making Something

What do the pros think? They tend to be more bullish, partly because they use valuation methods that compare earnings with bond yields. By dividing expected earnings on the S&P 500 by the index value, you arrive at what is called the earnings yield (currently, 57/1155, multiplied by 100 to get a percentage number). That indicator now reads 4.94%.

The 10-year Treasury bond's yield was 4.91% on Friday, so stocks were "yielding" slightly more. On a lot of occasions when stocks are yielding the same as bonds, stock markets have been seen as undervalued and have risen. There have been times, however, when rallies haven't taken place. In addition, the simple comparison of risk-free Treasuries with earnings is seen by many as hard to justify theoretically.

Tilting S&P 500 over a year

In fact, J.P. Morgan strategists believe that we are entering a phase when stocks need to be yielding significantly more than in recent years. Put differently, there's now a need for a higher equity risk premium. The Morgan strategists give three reasons for this: Profits margins are going to slim, inflation is likely to be higher than in the recent past and stocks have become a lot more volatile.

Money Finds Mouth

What if investors get increasingly risk-averse and start demanding that stocks yield 2 percentage points more than bonds? Taking the 2002 expected earnings of $63, the index would have to fall to 900 to yield 7%. Not as bad as the P/E-based model, but still over 20% down from current levels.

Alternatively, say inflation continues to trend up, forcing the Fed to start hiking rates, not a wholly unlikely scenario (see below). Bond yields would soar. And unless earnings rose considerably, stock yields would start to look less attractive against bond returns.

The fact is, even 2002 earnings may be hard to achieve. The market's profitability has been deteriorating for some time. The earnings growth actually slowed in the late '90s, when the New Era hype was at its most intense. The three-year average operating earnings growth in 2000 was 8%; the five-year average was 9%. In 1995, the three-year average was 18% and the five-year 11%.

Much confidence has been placed in the ability of the Federal Reserve to revive the economy and, thus, profits. But the chances of this happening are slim. Most of the profits growth took place among industries that supply big ticket goods and services to other businesses. In other words, the '90s saw a classic investment-led boom, in which private investment soared from around 12% to 19%, the highest ever number in government figures, which stretch back as far as 1929.

Out of You and Me

The problem is that this boom was always going to be unsustainable, since it wasn't financed through extra saving. Instead, driving it was cheap credit created by the banking system and the Fed, according to Paul Kasriel, chief economist at Northern Trust.

The Interest Rate Spike that Killed the Bull

Source: Detox

He explains why the Fed has trapped itself in a corner. First, low interest rates almost always lead to increased spending in capital goods businesses, like Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) or GE (GE Quote - Cramer on GE - Stock Picks), at the expense consumer spending and investment in consumer-focused businesses, like Wal-Mart (WMT Quote - Cramer on WMT - Stock Picks). Later, the investment boom leads to higher consumption, since wages in the capital goods industries flow through the economy.

However, the consumer and capital goods industries end up competing for capital and interest rates rise, unless the Fed underwrites the printing of more money. But it won't do that if it sees inflation in the economy. This is exactly what happened in 1999, when interest rates started spiking. The higher interest rates then render much of the capital goods investment less profitable and earnings slump, something seen in the latter part of 2000. Kasriel says the Fed is likely to try and stop a bust by continuing to cut interest rates. However, "more and more created credit is needed to prevent the bust, but consumer inflation is trending higher," he says. "So the Fed runs the risk of ratcheting inflation higher."

And if by the end of 2001, people are beginning to say that the Fed is going to hike rates, all stock valuations get mangled. The earnings come down even below today's much reduced forecasts. The bond yields go up.

And the New Economy truly dies.