Lower Prices Aren't the Same as Bargains

Anecdotes and Allegories

We had a garage sale this weekend, and from that admittedly small survey of the American consumer, the following conclusion can be drawn: People are still willing, even eager, to spend money, but they've got to feel they're getting a major bargain. Even high-quality items sold only if they were priced especially cheap.

Which brings us to the stock market, which was moving up at midday today amid some positive geopolitical developments and an ongoing debate over whether Friday's midday reversal was significant. Somewhat lost in that debate is the question of whether or not the market is cheap; that is, would it appeal to those who frequent Wall Street's version of a garage sale? The "early bird" arrivals who were buying shares at today's open seemed to think so, but the data suggest otherwise.

At Friday's close of 1027.53, the S&P 500's price-to-earnings ratio was 22.7, based on 2001's reported earnings of $45.16. Based on Thomson Financial/First Call's consensus expected 2002 earnings of $50.39, the index's P/E is 20.4. Using Standard & Poor's new "core earnings" criteria, the index's P/E is even higher. Any way you slice it, the market isn't "cheap" by historical or garage-sale standards.

Citing these facts and recent trading, the bears contend that any talk of the market having bottomed last week is faulty and facetious.

"Our work suggests that the market is historically expensive by nearly any measure," Richard Bernstein, chief U.S. strategist at Merrill Lynch, commented this morning. Declaring that the predictability of S&P earnings is at its lowest level in 55 years, Bernstein suggested that forecast earnings growth is tenuous and that already-high P/E ratios may actually understate the premium in equities. "These data do not mean that a market trough is impossible," he wrote. "Rather, they simply suggest that upside appreciation might be constrained."

High P/Es generally translate into a cheap cost of capital for companies, Bernstein continued, suggesting "a sizeable increase in the supply of equity could place a ceiling on market rallies," as discussed here last week.

High valuations and the risk to earnings forecasts -- in addition to his sell-side indicator and the "continued opaqueness of company reporting" -- suggest that "considerable risks remain within the equity market," Bernstein concluded, adding that the market won't reach a bottom until investors and pundits stop trying to anticipate its arrival. "We are still not convinced that a long-term, durable market bottom is in place. Realization is not capitulation."

Even if a long-term, sustainable bottom is far off, that doesn't mean a short-term tradeable rally can't surface, beginning today or soon hereafter. Bernstein's forecast for a rally "constrained" by a variety of factors is shared by many heretofore cautious -- and thus accurate -- market forecasters. But some of the hard-core bears (and I'm not saying Bernstein is in this camp) seem to give little or no thought to the possibility of even a countertrend rally, which is known to occur in bear markets.

On the other hand, Tom McManus, equity portfolio strategist at Banc of America Securities, has acknowledged the potential for short-term rallies within the broader downtrend. He did so in March 2001, in late September and again today, raising his recommended equity allocation from 50% to 55%, while reducing bonds from 45% to 40%. Cash remains at 5%. (Along with Bernstein, who maintains a recommended allocation of 50% stocks, 30% bonds and 20% cash, McManus has lately been among the most bearish of the so-called major Wall Street strategists.)

"Despite our continuing downbeat view of the economy, valuations in the market have improved, and investor sentiment has become more cautious," McManus wrote. "We do not view this opportunity to be as attractive as in March and September of last year, where we last increased our equity allocation. But ... given the recent string of losses in the market, we believe a rally may develop in the near term that could carry the popular averages a few percent higher and help rebuild bullish sentiment."

Various sentiment indicators are producing contrasting signals, but the surprising level of optimism about a near-term rally expressed late last week suggests it won't take much of an advance to rebuild bullish sentiment.