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Justice Is Sweet, but Stocks Are Still Pricey

Why the Wall Street settlement doesn't clear the way for a marketwide rally.
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Editor's Note: On Wednesday, Peter Eavis is hosting an interactive chat in which he'll discuss the five warning signs to look for in a company's financial statements -- and he'll also take questions from you. For more information about the chat, click here. This article appeared earlier today on

After being punished by regulators, stock analysts may refrain for a while from some of their worst behavior. Pity the same can't be said about the investors who gladly paid the commissions to Wall Street's touts.

Investors may have taken a great deal of financial pain in their stock portfolios over the past three years, but they have a newfound passion for overvalued stocks, judging by the recent market rally. Indeed, it is deeply ironic that a strong whiff of the old mania for equities should be present in the market just as brokerages are getting hit with $1.4 billion in penalties for allegedly issuing deceptive, conflict-ridden research. We all know analysts did naughty things, but the settlement with regulators will only serve to continue the dangerous lie that Wall Street research and crooked corporate chieftains were the only causes of the stock bubble of the '90s.

Also to blame, of course, was the

Federal Reserve

, which allowed the bubble to inflate to ridiculous levels. But a combination of greed, herd mentality and unquestioning intellect created a vast pool of cash-flush investors who clamored for the hyperbolic research that brokerages issued. Henry Blodget, soon to be $4 million poorer as a result of the settlement, wrote what he did because he knew he had a voracious market. Like acolytes at the feet of a guru, institutional investors waited on Jack Grubman's every word. Manias are like that.


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S&P 500

index jumped 1.8% Monday to 914.84, leaving it 14% above its yearly low.

So have investors recognized their mistakes? If only. Stocks are back trading at multiples that imply that U.S. corporations, which have given us several years of poor performance and cooked books, are now fully reformed and able to achieve ever-expanding profits. The S&P 500 trades at 18 times estimated 2003 operating earnings. That's a high multiple, even if we assume the earnings in the calculation are clean. And it may be a little too early to do that, given that they are projections made by Wall Street analysts and based mainly on earnings guidance from company officers that strips out all manner of inconvenient items.

On so-called reported earnings that add back all the nasty stuff, the S&P 500 is trading at a 24 multiple for 2003, using Standard & Poor's numbers. Let's be charitable and take a midpoint between operating and reported earnings, and we arrive at a multiple of 21 times.

What's so wrong with that? Aren't interest rates at historic lows that mean we can pay higher multiples? Isn't the economy recovering and set to cause a massive ramp in earnings?

Comparing the earnings yield on a stock -- i.e., dividing price by annual earnings per share -- to the yield on government bonds has been the lazy-minded investor's defense for buying overpriced stocks. There are several faulty premises involved in this approach. The low interest rates may signal disinflation and economic slowness that will accompany lower profits. The lower earnings could therefore offset the benefit of using a lower discount rate.

Also, this so-called Fed model is way too "macro" in approach. Shouldn't investors' prime motivation for buying individual companies be the strength of their management, their product, their market position and their use of capital? This says nothing about those things. For example, U.S. companies are still way overleveraged, and many of them are selling into deeply saturated markets. Finally, the Fed model also ignores the fact that stocks were trading at much lower price-to-earnings multiples in the '60s, when interest rates were just as low and productivity rates were substantially higher.

As for the economy, most investors are stuck in the Keynsian mindset that if the Fed cuts rates enough, growth will return. True, lower rates may save the country from a recession, but they also tend to prevent the sort of balance sheet restructuring that needs to take place in the personal and corporate sectors. As a result, the economy grows, but only slowly, as companies and individuals become cautious with spending because they are burdened by high debt levels. The more debt there is, the less book value there is left for shareholders. But it would seem that sometime in the last 20 years, investors stopped thinking of themselves as shareholders who sought managements that could create wealth over the long run. Instead, they sought managements that would talk up their stocks. Listening to mutual fund managers' comments on first-quarter earnings calls, that hasn't changed one bit.

Just like the regular kind, financial history repeats itself -- just all the more quickly.