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How Pricey Are Stocks?

Posted By Barry Ritholtz On December 8, 2003 @ 9:26 am In Finance | Comments Disabled

wsj_stocks_pricey.gif [1]

Its important to understand what “valuation” actually means when discussing market price: What makes stocks expensive or cheap?

One common measure is P/E: What does a $1 worth of earnings cost? Take a look at the S&P500 P/E chart (top, above) from today’s WSJ. The P/E spike in 2001/2002 came about not because stock prices were soaring — they were actually racing the other way; Rather, stocks got expensive on a P/E basis due to disappearing earnings. The popping bubble was accompanied by plummetting sales and profits, and on a strict P/E basis, made stocks look terribly expensive. On an earnings basis, stocks became dear because as fast as prices were falling, earnings were dropping even quicker. Hence, your investment dollar bought less and less profit.

In 2003, the P/E multiple has pulled back from near 30 towards 26 or so. That decrease occured as stock prices rose rapidly. Counterintuitive as that may sound, its simply the same situation as ’01/02, only in reverse: Earnings went up faster than did stock prices.

Ironically, when stocks reach extreme P/Es due to earnings contaction (NOT when due to rising stock prices), that’s a good time to begin looking for the cyclical turn. Often, that precedes an ideal entry point for buying equities by a few months. The underlying thesis is that at recessionary bottoms, things look awful and P/Es are outrageous. As the turn comes, most observers are still trapped in the cycle of negative news. In the 2000-03 Bear market, those entry points were the July and October 2002 lows, and the March 2003 bottom.

As the Wall Street Journal notes, the fattest gains often come in the earliest parts of a rally:

“Historically, the best stock gains tend to come at the start of an economic rebound, not in the middle. There have been exceptions to this, most notably the rollicking bull market of the late 1990s. But in a more-typical bull market, the stock market tends to level off as the recovery hits its stride — a time when earnings gains cease to be dazzling and become merely strong or just average.”

Source:
Stocks, Not a Bargain Now, May Get Even Pricier [1]
By E.S. Browning
Wall Street Journal, December 8, 2003

http://online.wsj.com/article/0,,SB107063400977086000,00.html


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