Stock Market: Time to Be Greedy or Cautious?

By: Billy Alpert

Generally, the 2000s decade has been rather unkind to investors of the US stock markets. The popular index used as a barometer for US stocks, the Standard and Poor’s 500 Index, emphasizes this point as it includes the stocks of the largest 500 public companies in the U.S. The S&P 500 entered the decade at 1,469 to begin the year 2000, and as of the close of June 30, 2009, the half way mark for 2009, the S&P 500 was at 919. The less than stellar 2000s has thus far lost stock investors in excess of 37% of wealth as measured by the broad S&P 500 Index.

Many pundits often tout how stocks are the best investment for the long term, and then point to the recent lackluster performance present both in the last year and the last decade as a sign that stocks are due for an explosive move up in the near future to compensate. These musings seem to coincide with calls for economic recovery, which has led to a sense of optimism on Wall Street of late. The S&P 500 rallied 38% off the satanic low of 666 made on March 6, to close the second quarter of 2009 at 919 which explains much of the optimism.

Rather than arbitrarily making calls about where the S&P will go, I’ve decided to give a brief review of the valuations - what better way to predict the valuations for US corporations than to look at data of their profits. Generally, the most simple and common method of valuing stocks or any business is by formulating a ratio between the price of the stock and the annual earnings or profits, per share, for the corporation. For indexes like the S&P, the earnings are for the entire index based on different weightings for each company based on size. This nifty method of valuation which compares the Price of stocks to the annual Earnings is unsurprisingly referred to as the PE ratio. The average PE ratio for stocks over the last century has been roughly 15, which means on average the price of stocks are 15X the amount of profit or earnings they generate per year. Currently, based on the earnings of 2008, the S&P 500 index has a PE ratio of 62, and based on the projected earnings for the year 2009, that ratio is still 32. Even if profit projections are hit for 2009, the stock valuations are still over twice as high as the historical average PE ratio of 15.

There are many other methods of valuing stocks, but the PE ratio method is quite simple and informative. Overall, it appears that now is the time to be cautious not optimistic about US stocks and the S&P 500 Index based on the valuations of the stocks, especially since the index is already up near 40% off the lows of March. Although stocks have been rising over the last few months, historically the stock market never continues in the same direction but always reverses and corrects, and when looking at history, one may tend to favor the idea that the stock market is just correcting upward on its longer term descent lower to generate more historically normal valuations.