It's the P/E's, Stupid, Which Keep Feeding Those Tech Bears

Are we getting too bearish on tech, folks?

That's a question you might want to ask yourself as Wall Street and investors take out and shoot yet more of yesterday's market leaders. (Sayonara, Cisco(CSCO Quote)?)

Whether you are a growth stock investor, a value investor or a momentum trader, you want to get a handle on whether this remains the time to hide in defensive stocks -- as clearly it has been for the past six months -- or whether this is the moment to come out of your hole and buy some of the beaten-up tech names.

You know the economic bear case against high-priced fast growers. It keys off the fears swirling through investors' heads today. Real interest rates remain high. Global growth is slowing, especially in Asia and Europe, as oil prices stay higher longer than expected. U.S. gross domestic product is losing momentum, too.

Capital expenditures and consumer spending are weakening. (Even growth in information technology spending may be easing, according to a recent survey by the International Strategy & Investment Group, which found, surprisingly, that only about half of the 58 companies polled said they planned to spend more on IT in 2001 than they did this year.)

Oil and natural gas prices remain higher than expected and siphon yet more purchasing power out of the world's economies. U.S. retailers continue to report lousy sales despite heavy promotions. U.S. auto sales have been declining this month.

Alcoa(AA Quote), the world's biggest aluminum manufacturer, sees weaker demand for its metal. It has been cutting prices and building inventories. Then there are the political uncertainties surrounding the presidential race, a new presidential administration and possible renewed violence in the Middle East. And we haven't even talked about the euro or the possibility of financial crises overseas or in the U.S. Sounds pretty dreary, doesn't it?

But, don't we all know about these economic shoals? If you think that the stock market is essentially a giant discounting machine, then you also should agree that some of the bad news is already priced into stocks. It also explains why so many high-priced stocks have been clocked this year. And it is not as if we are clearly about to head into recession. It's too soon to tell.

As Credit Suisse First Boston's bullish strategist Tom Galvin noted in a report today, "Sixty percent of S&P 500 stocks have fallen in October and 62% of the S&P industry groups are down. ...Valuations have been cut by 15%. PE multiples are the lowest in three years and the mutual fund tax-loss selling season has ended. Importantly, we are entering the best part of the year for money flows into equity mutual funds, and cash levels are already high. Remember, sell into confidence and buy into fear. Stay Bullish!"

So why are many investors hesitating, Tom? Why isn't it clear to them that the smart, moneymaking thing to do now is to plunge in and buy? The reason may be that somewhere down deep they realize that too many of the stars of this market are not yet selling at prices typically found at major market bottoms.

The facts suggest that people are right to be cautious. I received a wonderful fax today from Deutsche Banc Alex. Brown's economists Debbie Johnson and Ed Yardeni that illustrates the problem. Looking at various S&P technology stock indices, Johnson and Yardeni show that while the air had been coming out of the tech wreck, in many cases the P/E's remain historically high.

For instance, the 12-month estimated P/E for the overall S&P technology sector is still about 30; it was about 14 in 1996. The P/E for the S&P's boxmakers is about 25, vs. 10 four years ago. And for the computer networking companies -- Cisco, et al -- the forward P/E is about 70 compared with 20 four years ago. That ain't cheap. (Only the S&P semiconductor equipment index trades at a multiple anywhere near its 1996 level.)

We could certainly get a trading rally off current levels. Who knows? It is possible that last week we saw a convulsive shakeout when fiber opticals Ciena(CIEN Quote), JDS Uniphase(JDSU Quote) and Nortel(NT Quote) handed investors $85 billion in losses, according to technical analyst Tom Beale of Yankee Prognostics.

Beale believes we already may have seen the lows for the S&P 500 and the Dow Jones Industrial Average . He is less sure about the tech-heavy Nasdaq . He needs to see more convulsion before calling a bottom of any kind for the Comp.

There are, nonetheless, opportunities to go long. In the downturn we are experiencing today, I still believe that investors will rotate into different sectors within the stock market rather than flee altogether. I like sectors whose prices more accurately reflect the risks inherent today in the stock market. Which ones are they? The sectors that have been doing relatively well since the slide began in March -- health care, energy, food, beverages, liquor, tobacco, cosmetics, restaurants and some financials. Have you taken a look at Philip Morris(MO Quote) recently?

MO Has Momentum Tobacco kingpin Philip Morris has a comely P/E ratio; here's how it stacks up against Cisco shares lately

What I like about Philip Morris and the rest is their "earnings reliability," to quote a recent report from the folks at Ned Davis Research. The chances of them missing their earnings and revenue estimates is less than for a Cisco or Nortel or JDSU, and they are far less expensive, too. Philip Morris, for example, has a trailing 12-month P/E of 9. Cisco's is about 150. That is too much of a premium to pay in the face of the current uncertainty.

Let me leave you with a historical note courtesy of Sam Burns, who works for Ned Davis. He and his colleagues track the degree to which government bonds yield more or less than stocks earn. When Treasury bonds yield considerably more than the S&P 500 companies yield as measured by operating earnings, stocks are not cheap. Remember, with a government bond you know you are going to get the income and the principle, too. With a stock, there is no guarantee that earnings will come through or that you will get the price you paid for the security if you want to sell.

Burns has found that, historically, when investors paid up for stocks when the earnings yield was far lower than the bond yield, they lost money. That makes intuitive sense. After all, if you do that you are in effect betting that those corporate earnings are as much of a sure thing as a T-bond. In an uncertain world like ours, that is not a smart bet.

Today, the ratio of the Treasury bond yield to the S&P 500 operating earnings yield is 1.5, according to Davis. That is lower than the 2.0 ratio of late 1999, when so many investors were bullish to the max. But 1.5 is not a level we normally see at a bottom; 1.5 is nowhere near the 1.1 reading set at the low of the nasty little bear market of midsummer 1998. Unless you think the future for the economy and corporate profits is dramatically brighter today than in 1998, you should pay attention to this indicator. And you should beware companies with great expectations and P/E's to match.