Stocks' Retreat Reopens Valuation Debate

But most agree it's too early to call the market undervalued.
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The dramatic declines on Wall Street last week went a long way toward bringing stock prices back into line with historical valuation models. Whether that means they're headed back up is another question.

The three major indices have dropped back to their September 1998 levels. Valuations, which many thought swung far too high during the bull market of 1999 and 2000, are now below some theoretical measures of fair value. But profits, which are one side of the valuation equation, are still such a question mark that what look like bargains might be anything but.

"You can't really look at

price-to-earnings ratios at the moment because they don't reflect what's surely to come in the next month," said Chuck Hill, director of research at First Call/Thomson Financial. The

S&P 500

"is now 12% undervalued, but that's obviously based on too high an earnings number, even with what we know now."

Worst Still to Come?

Valuations are an attempt to model the relationship between a company's real-world fortunes -- its revenues, earnings, cash flow -- and the price of its stock. Hill uses a reciprocal of the 10-year Treasury note to establish fair value for the S&P 500. According to Hill, the index, which is generally taken as a reflection of the broader market, "is a good chunk undervalued," trading around 18.5 times forward earnings, compared with fair value of about 21.3 times earnings.

But the main problem, Hill said, is that earnings estimates are, for now, meaningless. Businesses, which were already in the profit doldrums, are slowly tabulating the impact of the terrorist attacks. The latest earnings pre-announcement update by Thomson Financial/First Call shows that 69 profit warnings were issued since Sept. 11, compared with 86 over the same period in the second quarter. Most of the warnings came after the market reopened last Monday.

Hill believes "another wave" of warnings will come from consumer cyclical companies, citing

worries about the weakening consumer. "If I'm sitting here as a retail analyst, I know I've got to cut my numbers. But what will I cut them to? I have no idea what kind of consumer spending patterns are going to emerge."

Analysts have been "slow to respond to what's out there, let alone what's maybe going to come," Hill added, noting that only five out of 16 analysts have cut their full-year 2001 earnings estimates for the S&P 500 since last Tuesday. The consensus earnings estimate now stands at $44.58 for 2001, compared with a previous estimate of $49.25. The consensus estimate from the 16 analysts for 2002 is now $51.21, down from a pre-Sept. 11 figure of $56.70. Only five analysts have cut their 2002 estimates, said Hill, as the other 11 still have "no clue."

"We're going to be bombarded with significant negative news for the next month or so," he said. "Unfortunately, it's not going to get out of the way in the next week because of the consumer cyclical

sector."

Playing with Fear

Last week's broad selloff, which affected stocks in nearly every sector, created many good values in the market, said Jeff Ament, associate vice president at Dain Rauscher. However, Ament doesn't believe valuations are guiding market activity right now. "It's a matter of sentiment, and right now people just don't have the stomach to be buying," he said.

Tim Truebenbach, president and growth fund manager at True Capital Management, said he's now "in cash" as the market has given him no reason to own stocks. Valuations are cheaper, but "growth is decelerating." And stocks will climb only "if we had a grip on this terrorist thing." Nevertheless, Truebenbach believes some good companies are "getting dragged down," and that he'll be digging for cheap values in "obliterated" sectors like technology when the political and economic situation stabilizes.

Instead of its P/E ratio, a company's cash flow is "a huge issue" right now, said Dana Feike, market strategist at Wilke/Thompson. Given the downturn in the financial markets, companies should be able to demonstrate the ability to stay afloat, pay their bills, and fund new business initiatives, said Feike, who's a self-described long-term investor.

Economists believe the latest fiscal and monetary interventions will have a visible impact on the economy by next year. The

Federal Reserve

lowered short-term interest rates for the eighth time this year to 3% from 3.5% last Monday, and many expect rates to be at 2% by the year's end. Valuations, which tend to be higher when interest rates are lower, should also improve as a result of higher corporate profits next year.

"I really think economic activity will return, and the market will rally," said Kent Engelke, capital markets strategist at Anderson & Strudwick. But "I'm not going to buy anything until I see some semblance of order, not only from a political resolution, but also on what's in the market."