Playing Rope-a-Dope With This Tape

Sure, stocks are up sharply in the last two months. But how long until they tire?
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Baby, you don't ever want to fight the tape.

You fight the tape, and the tape and its friend the trend are going to mess you up. Stop saying that the move higher in stocks doesn't make sense, or that valuations don't make sense. You don't want to get on the tape's bad side, do you?

Of course not. The market's up 20% in the last two months, and most of us wouldn't have expected that, would we? No. So let's take a look at what the market is telling us about what we should expect over the next year or so. There's a bunch of different models we can use to do this -- and they're all telling us that life in 2002 is going to be sweet. As long as you don't mind assuming that the economy has entered a new era, that is.

First Things First

The trailing

price-to-earnings ratio on the benchmark

S&P 500 is around 23. (That's if you calculate earnings the way Thomson Financial/First Call does; if you insist on Standard & Poor's more orthodox methods, you'll get a P/E of 27.) Over the past 15 years, the S&P's median P/E-to-expected-growth-rate has been about 1. So maybe the market's telling us corporate profits are going to grow by about 23% next year.

Another way of valuing the market is the so-called

Fed

model (so-called because, other than an oblique reference in some testimony from Alan Greenspan, there's no indication that anyone in the Fed actually uses it). The Fed model throws interest rates into the valuation equation -- lower rates support richer valuations, and so on. The simplest derivation of the model is to take your forward earnings expectations, divide them by the yield on the 10-year bond and then multiply the whole thing by 100. Under that criteria, S&P 500 earnings would have to grow by around 15% over the next year.

Some people use similar models, but because this isn't your father's S&P, throw in a little math to account for changes in the S&P's makeup, changes in long-term assumptions about risk and so on. The way J.P. Morgan's Doug Cliggott adds it up, the S&P would need to see earnings grow by about 18% to justify current prices. (Again, this is if you're looking at earnings the way First Call puts them together, with all the one-time charges backed out.)

Misery Loves It

Others eschew models that use Treasury yields (bonds are trading instruments, after all, and therefore volatile), and instead use the inflation rate. This is the way Banc of America Securities equity portfolio strategist Tom McManus tries to put a price on the market. "We'd have to get practically 10% growth in earnings next year to justify current levels," he says.

Ah, you sniffed it out: McManus doesn't believe in the rally. The fool is fighting the tape.

If he's a fool, he's got company. Even if the economy rebounds smartly sometime in 2002, year-on-year growth will be hard to muster. The problem is that, despite some signs that the slide may have moderated, the economy is still weak. According to Salomon Smith Barney economist Steve Wieting, even if the recession is already over (unlikely), earnings will continue to deteriorate at least through the winter. Even company analysts, a sanguine lot, expect S&P earnings to decline by 6.4% in the first quarter of 2002 over the year-ago period. That estimate is getting steadily revised down.

"Earnings will, on balance, be fairly flat next year, with a decline in the first half and a rapid recovery in the second half," Wieting said.

McManus and Cliggott concur. Part of the problem for earnings to snap back early is that even as the economy recovers, margins likely will remain under pressure for a while more. To begin with, pricing power is going to be hard for many companies to get back. On top of that, even though sales and industrial production peaked more than a year ago, real income has continued to rise. It's hard to see margins expanding until sales start growing faster than income again.

Wieting also notes that it took years for earnings to recapture prerecession levels in the early 1990s. Company analysts expect that to start happening by the end of next year. And yet these optimists believe earnings will grow by "only" 15% in 2002, meaning the market is, at best, fairly valued under most of the models we've looked at.

The Flip Side

Careful readers might argue that comparing 2002 earnings with 2001 earnings now is throwing a sop to bulls -- 2001 isn't over yet, after all. What do the company analysts think earnings growth looks like over the next four quarters? Answer: about 2%.

Of course, what the valuation models say doesn't necessarily mean the market has gotten ahead of itself. Things change and, with them, the way we look at risk. The last two expansions have been the third-longest and longest in U.S. history, and perhaps that evidence of decreased economic volatility means the market should carry a significantly richer valuation than before. The bust in tech stocks does not erase the significant boost that technological development has given to U.S. productivity, and if those productivity gains continue, the economy should be able to run at a much faster clip.

Stop me if you've heard all this before.

J.P. Morgan's Cliggott admits that his idea of appropriate valuation may be antiquated. "I can't factually demonstrate that it isn't," he says. "But buying stocks now should come with the same kind of warning that comes on a pack of cigarettes. It only makes sense to be adding equity exposure to your overall portfolio if you think we're in a new era."