Taking Apart The Stock Market

The stock market has seemed almost like an alternate reality so far in 2013. The question for investors is whether they should buy into the optimism of that alternate reality -- or heed the warning signs from the rest of the economic world.

The S&P 500 rose by more than 6 percent in the first two months of 2013. This rally occurred against a strange backdrop. Early estimates of Gross Domestic Product (GDP) indicated that economic growth virtually ground to a halt in late 2012. Meanwhile, budget confrontations in Washington provided frequent reminders that the U.S. budget deficit was likely to be a drag on the economy for years to come. As if that weren't bad enough, the contentious handling of the budget created an atmosphere of uncertainty that discourages private sector growth.

So which is right: the stock market or the grim headlines? One way to approach that question is to look at the stock market in greater detail. A look at earnings and dividends reveals some things to like about the stock market -- and some things not to like.

What to like about the stock market

  1. The price-to-earnings ratio. At the end of 2012, the price-to-earnings ratio (P/E) of the S&P 500 was at 16.21. With early 2013 rally in stock prices, it had crept up to 17.22 by the end of February. That's not cheap, but it's not terribly expensive either. Consider that from the end of 1995 till late 2005 the S&P 500 went nearly 10 years without its P/E once dropping below 18. In fact, earnings had just started to catch up with stock prices when the financial crisis and Great Recession hit, knocking earnings back about a decade. P/E is a good tool for putting stock prices into some perspective. It measures the price you are paying for companies relative to their ability to make money.
  2. Dividend yield. The dividend yield on the S&P 500 is a little above 2 percent. At a time when savings account interest rates are near zero and bond yields are below 2 percent, this makes stocks a decent source of income. Just keep in mind, though, that with stocks neither their value nor their dividends are guaranteed.

What not to like about the stock market

  1. Flat earnings growth. As the economy recovered from the Great Recession, trailing 12-month earnings on the S&P 500 grew by 51.76 percent in 2010, then by 12.41 percent in 2011, and most recently by 1.16 percent in 2012. That trend paints a picture of earnings growth that is flattening out, which certainly doesn't support the recent rise in stock prices.
  2. Accounting magic. The flattening of earnings growth is even more pronounced if you look at operating earnings rather than reported earnings. Fourth-quarter 2012 operating earnings were the lowest posted by the S&P 500 since early 2011. This means that some of the growth in reported earnings is due to accounting treatments and extraordinary events and doesn't necessarily reflect anything fundamental about the underlying business operations of companies in the S&P 500.

Standard & Poors estimates that both reported and operating earnings will see double-digit growth rates in 2013. If that growth comes through, current stock prices will prove to have been quite reasonable. If that growth stalls, however, the early-year rally will only have increased the risk of the stock market.