Monday Morning: No consensus on the market’s value

Are stocks cheap yet?

On this long trip to heaven-knows-where in the capital markets, the stock market seems to be saying no. But the market usually overreacts on the downside, just as it does on the way up.

Judging by the materials floating over my desk in the past two weeks, there is no consensus among investment professionals. While few think the market is cheap, some think it is getting close to being fairly valued.

Of course, a few pessimists, including famed bond manager Bill Gross of Pacific Investment Management Co. in Newport Beach, Calif., think it still has a way to fall.

James W. Paulsen, Minneapolis-based chief investment officer at Wells Capital Management Inc., is one of those who thinks stocks are now cheap, at least relative to 10-year Treasuries. He calculates the price-earnings ratio for the median company in the Standard & Poor’s 500 stock index as 16.5 times earnings, based on projected earnings for the next year.

That converts to an earnings yield (earnings divided by price) of almost 6.1%, compared with yields of just over 4% on 10-year Treasuries. Thus, Mr. Paulsen says in his monthly commentary, there’s ample room for the stock market to move higher and bring that earnings yield closer to the Treasury yield.

In fact, he says, the gap between the median S&P 500 company’s earnings yield and the 10-year Treasury yield is now the widest it has been since 1982, when the recently deceased bull market began.

“The market might not be cheap on an absolute basis, but it is also no longer grossly overvalued,” Mr. Paulsen says.

Nevertheless, he says, the financial markets are saying that the economy will likely slow markedly in upcoming quarters.

Eric Bjorgen, a senior research analyst at the Leuthold Group, also in Minneapolis, argues that the stock market is much less overvalued that it was and is perhaps even fairly valued.

He notes in the group’s monthly publication “Perception for the Professional” that total market capitalization as a percentage of gross domestic product, a measure of market valuation, is 101%, the lowest it has been since June 1996. That is a 46% drop from peak valuation levels at the end of 1999.

That 101% is still high by historical standards. The median ratio for 1926 to date is 51.2%.

But Mr. Bjorgen argues that historical medians are no longer valid as “fair value” proxies for the stock market because the profiles of both the stock market and the U.S. economy have changed drastically over the past several decades.

He notes that the ratio of stock market capitalization to GDP has been rising since 1926, and the trend line from 1957 to the present suggests a fair-value ratio today of 100, only slightly below the current level.

Focusing on yield

On the other hand, Pimco’s Mr. Gross wrote in his September newsletter that “stocks stink and will continue to do so until they’re priced appropriately, probably around Dow 5000, S&P 650 or Nasdaq God-knows-where.” He says that the primary element in determining whether a stock market is cheap or expensive is yield – dividends divided by price.

In 1900, Mr. Gross notes, the yield was 4.2%. Today it is “somewhere in the area of 1.7%.”

For the market to have any hope of returning the historic real rate of return of 6.7% a year, that is, for it to be cheap again, the market dividend yield would have to be lifted to 4.7%.

The only way to do that, he says, would be to cut the market averages in half or more. “Dow 4000 would do it, as would S&P 400.”

That is way too pessimistic even for Mr. Gross, so he tries another approach, adding the historic equity risk premium of 2.7% to the 3% inflation-protected yield you can earn today risk-free on Treasury inflation-protected securities. To achieve that 5.7% return, he says, the Dow has to fall to about 5000.

But take heart. Jeremy Siegel, author of “Stocks for the Long Run” (McGraw Hill Trade, 2002), says stocks’ after-tax real return is higher than Mr. Gross allows.

The result, Mr. Siegel argues – a 5% real return on stocks implied long term by the market at current levels – corresponds to a 2.3% premium over Tips on a before-tax basis, and a 3.1% premium on an after-tax basis. Therefore, no further decline in stock prices is needed.

Right, but does the market know this? Because the market usually overshoots both ways, I wouldn’t bet that we have hit bottom yet.

After all, the 1973-74 bear market almost cut the Dow in half. If that happened again, it would fall below 6000 before it recovered.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.