The Wall Street Journal-20080119-When Is It Time to Buy Stocks Again-- One Yardstick Says Now But Few Are Convinced- Earnings Dangers Lurk
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When Is It Time to Buy Stocks Again?; One Yardstick Says Now But Few Are Convinced; Earnings Dangers Lurk
Even as investors flee the battered stock market and rush to the safety of Treasury bonds, one market indicator is screaming they have it backward: Stocks are a bargain and Treasurys are massively overpriced.
Maybe, maybe not.
The task of trying to decide whether an investment is cheap or expensive is a treacherous game. Just because something may be cheap, compared with its history or its potential, doesn't mean it won't get even cheaper in the short or medium term -- just ask the value investors who loaded up on financial stocks that seemed cheap last summer only to suffer double-digit losses that may not be recouped anytime soon.
The indicator shouting "buy" for stocks is commonly known as the "Fed Model" and compares yields on stocks with the yield on 10-year U.S. Treasurys. Even the economist who popularized the theory during the late 1990s thinks it may now be flashing a false green light. "It has been a lousy indicator," says Edward Yardeni, president of Yardeni Research Inc. "It hasn't worked this entire decade."
Many on Wall Street think that buying U.S. Treasurys now may be a money-losing proposition when factoring in inflation, and that bonds are vulnerable to price declines. At the same time, many like Mr. Yardeni think stocks are in for more trouble. "I don't think there is much upside over the next few months," he says. "The mess just keeps spreading."
Other market barometers also indicate that stocks are more attractive than they were a few months ago, but not to the degree that would suggest fire-sale prices. In addition, there's wariness about any signals to buy because a key element of these measures -- earnings forecasts -- may not fully account for the impact of a recession. If earnings come in lower, that means stocks aren't the kind of great deal they appear to be right now.
Some, however, think the Fed model still has value. "You can't take some of these indicators too literally...but any way you measure it, at this juncture stocks are the cheapest asset class around," says Michael Darda, chief economist at MKM Partners LLC.
With the past week's downturn, stocks in the Standard and Poor's 500-stock index are trading at 13 times their expected earnings for 2008. Last June, when the S&P index was 12% higher than it is now, stocks were priced at 14.2 times this year's earnings. Meanwhile, with a U.S. recession now widely expected and the Federal Reserve thought likely to cut short-term rates further, U.S. Treasury yields have fallen sharply. The 10-year Treasury note is yielding 3.64%, its lowest level since July 2003, and down from 3.81% a week ago.
When Mr. Yardeni was working for a brokerage firm in 1997, he was struck by data in a Federal Reserve report comparing U.S. Treasury yields with a stock-market measure known as the forward earnings yield, which, put simply, is a measure that compares a company's expected earnings with its share price -- the reverse of the better- known price-to-earnings ratio. In his research, Mr. Yardeni found that tracking the relative value of stocks and bonds on this basis had been a good indicator for whether stocks were a buy or a sell, compared with bonds.
"It was really fantastic in the late '90s," Mr. Yardeni says. "It was screaming at us that we were nuts and stocks were grossly overvalued relative to bonds."
By that measure, stocks today have a forward yield of 7.63%, well above the 3.64% on the 10-year note. "That's an extreme reading," says MKM's Mr. Darda. He acknowledges that U.S. Treasury yields may be at unreasonably low levels, thus making stocks appear cheaper than they really are in comparison. But even compared with corporate bonds, which are yielding 6.5% based on Moody's investment-grade bond index, stocks are undervalued, he says.
Howard Simons, strategist at Bianco Research LLC, argues that the earnings variable, which is based on the forecasts of Wall Street analysts, undermines the reliability of the Fed model at this point. Given the uncertain economic outlook, he says, "stock analysts really have no idea what they are talking about in terms of forward-looking expectations."
A case in point: Last summer, analysts' forecasts called for a 7.7% rise in earnings for companies in the S&P 500 last year. In large part as a result of the multi-billion-dollar write-downs of losses on problem mortgage investments, it now appears that earnings generated by S&P 500 firms will have fallen 3.3% in 2007, once all reports are in, according to S&P's senior index analyst, Howard Silverblatt.
Based on other measures, the case for buying stocks is there, but less clear-cut. S&P stocks are changing hands at about 15 times earnings for the past 12 months, below the average of 19.4 times trailing earnings since 1988, according to S&P.
At UBS Global Asset Management, senior asset-allocation strategist Greg Fedorinchik looks at how the stock market measures up based on the cash it will generate in the future. "We see U.S. equities as being about 10% to 15% too cheap," he says. U.S. Treasurys, meanwhile, are about 7% overvalued, UBS believes.
