Stocks Look Cheap But They Could Get Cheaper

MARKET SNAPSHOT

Stocks look cheap, but they could get cheaper By some measures, P/E ratios are near lows, though it depends how you slice it By Laura Mandaro, MarketWatch Last update: 1:16 p.m. EST March 6, 2009

SAN FRANCISCO (MarketWatch) -- Price-to-earnings ratios, a popular measure of how expensive stocks are by historical standards, have surpassed lows seen in recent recessions. But that's no guarantee they won't sink further. "There's no doubt that people can look at market valuations and determine that stocks are relatively inexpensive -- but that doesn't mean they're going to quit going down," said Michael Gibbs, director of equity strategy at Morgan Keegan & Co. in Memphis, Tenn. The price-to-earnings ratio of stocks in the S&P 500 has sunk to 10.6 from nearly 17 at the end of 2007, says FactSet Research. That's based on the Thursday close of the S&P 500 compared to index members' past four quarters of operating earnings, or net income excluding what analysts consider to be extraordinary charges and gains. Thomson Reuters, which publishes similar analysis, estimates the trailing P/E ratio for the S&P 500 is around 11. Those numbers are well below the valuations reached during the market low of the 2001 recession, when the ratio stopped at 19. They're also lower than the P/E ratio of 13 touched at the market bottom during the 1990-1991 recession, says Morgan Keegan, which used data compiled by Yale University's Robert Shiller for its historical research. But widen out the lens, and P/E ratios dropped even further in some earlier recessions. During the market low of the early 1980's recession, for example, stocks in the index were trading at a mere 8 times earnings. "There have been periods when the market multiple [P/E ratio] traded lower. And the economy is declining at a rapid pace, meaning earnings could fall more," Gibbs said. Friday stock slide On Friday, the U.S. benchmark indexes gave up early gains after a brief rally at the open that followed February job losses that weren't as bad as some had feared. In early afternoon trading, the S&P 500 ( $SPX670.35, -12.20, -1.8%) had fallen 1.2% to 674.62 points, and the Dow Jones Industrials Average $INDU6,511.69, -82.75, -1.2%) was 0.9% lower at 6,536.38 points. The Nasdaq Composite (COMP 1,273.94, -25.65, -2.0%) pushed through new six-year lows and was recently down 1.5% at 1,280.56. Read more on tech stocks. The U.S. Labor Department said nonfarm payrolls shrank by 651,000 in February, slightly higher than economists had expected but lower than the 750,000 to 800,000 some market participants had feared. Read more on labor market. "This morning's news wasn't exactly uplifting," said Ken Tower, senior vice president in institutional research at Quantitative Analysis Service in Jersey City, New Jersey. "It could just be that people are digesting news from the morning," he said, adding that it's not surprising in today's trading environment to see big intraday swings.

At the same time, traders were poised for more bad news out of Detroit. General Motors Corporation GM1.41, -0.45, -24.2%) shares skidded 21% lower to $1.47, with the component of both the Dow and S&P 500 touching a new 75-year low. See full story on GM. President Barack Obama's automotive task force will hold a closed-door meeting Friday afternoon to discuss the restructuring plans from GM and Chrysler. "Language coming from GM is that bankruptcy is coming more of a potential event, that's spooking the market," Morgan Keegan's Gibbs said. On Thursday, the troubled automaker reiterated in a Securities and Exchange Commission filing that bankruptcy is a possibility its viability plan, as submitted to Congress, doesn't succeed. The S&P 500 and Dow industrials have lost about 8% this week. Year-to-date, the S&P 500 and the Dow industrials have tumbled about 25%. Bargain buyers burnt

Stocks look cheap, but they could get cheaper The stock market's performance this year is punishing investors who couldn't resist the call of bargain stocks when the S&P 500 ($SPX: 671.66, -10.89, -1.6%) hit 741 on Nov. 21 -- until recently, considered the low of this current bear market. At the time, investment strategists were calling stocks cheap. Stocks have fallen 7% since the close that day. One difficulty in using price-to-earnings ratios for historical comparisons is the plethora of ways to slice and dice P/E ratios. Some strategists look at today's prices compared to earnings from the past 12 months. Some look at prices compared to estimates for the next 12 months. Some use operating earnings, while others use reported earnings. Robert Kavcic, an economist at BMO Capital Markets, has tried to overcome some of the short-term fluctuations by taking a very long view of what he terms "trend earnings." These are reported earnings, meaning they include all those lumpy gains and charges from selling a business line or winning a court case, which Kavcic has then averaged for the index over periods of 10 years. He said that in past major bear markets, such as the one that ended in 1982, P/E multiples dropped under 10. They also dropped well below 10 during the Great Depression and in the 1970s. By his analysis, P/E ratios using trend earnings are about 13 now. "In that sense you have quite a bit more to go," he said. But he adds that the earnings could still expand again before they get lower. "It doesn't mean where you're going is a straight line. Just the opposite -- you'll probably see a substantial rebound before we get there," he said. And this cycle -- for all its eerie similarities with past prolonged bear markets and recessions -- has one thing going for it that other periods with market multiples under 10 did not: The U.S. economy isn't wrestling with high inflation. In the mid-1970s and early 1980s, when P/E ratios sank below 8 at market bottoms, Morgan Keegan's Gibbs points out, inflation topped 12%. Now, the broad consumer index is running flat with year-ago levels. "You would expect the multiple to be higher now than in the mid-1970s because the rate of inflation is so different," Gibbs said.

Laura Mandaro is a reporter for MarketWatch in San Francisco