Sunday 22 February 2009

Stocks and Earnings: Racing to the Bottom

November 20, 2008,
Stocks and Earnings: Racing to the Bottom
By David Leonhardt
One problem for the stock market right now is that estimates of corporate earnings are falling almost as fast as share prices.

That means that even as stocks lose value, they are not really getting cheaper — at least in the way that their valuation is most commonly measured (which is relative to the earnings of the underlying companies). Just to keep from getting more expensive, stocks have had to fall.

After today’s drop, the Standard & Poor 500-stock index has dropped 14.2 percent since Oct. 24, for instance. But S.&P.’s estimates for the net earnings of the 500 companies in its index has dropped 13.9 percent over that same four-week span. (Thanks to Howard Silverblatt of S.&P. for these numbers. They are for the year ending June 30, 2009.) S.&P. has had to lower its earnings estimates because the deteriorating economy is causing companies to lower their own estimates.

The standard measure of stocks’ valuation is the price-earnings ratio: the stock price of the average company in the S.&P. 500 company divided by its annual earnings. Right now, the forward-looking version of that ratio — today’s stock price, divided by estimated earnings over the next year — is about 16, which also happens to be roughly its average over the last century. By this measure, in other words, stocks are not yet inexpensive despite the enormous losses of the last year.

Some stock watchers — like John Bogle of Vanguard and Robert Shiller, the author of “Irrational Exurberance” — prefer a longer-term P/E ratio, one that is based on 10 years of earnings. That helps control for the sharp declines in corporate earnings during a recession. By this measure, the P/E ratio appears to be about 13.

That is below its historical average — and offers some reason to think stocks are starting to become cheap. On the other hand, that ratio bottomed out at close to 5 during the other two great bear markets of the past century, in the 1930s and the 1970s and early 80s.
Stocks are definitely becoming cheaper. If you are a long-term investor, they may even be worth buying at this point. But they may still have a ways to fall.


http://economix.blogs.nytimes.com/2008/11/20/stocks-and-earnings-racing-to-the-bottom/

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