In a sign that the economy may be on the verge of another recession, investors are paying less for equities than they have during every recession since Ronald Reagan was president
In a sign that the economy may be on the verge of another recession, investors are paying less for equities than they have during every recession since Ronald Reagan was president.
The S&P 500 lost 13% in the past five weeks through last Monday, sending its price-earnings ratio down to 12.9. That is 3.5% less than the average multiple during the 10 contractions since 1949 and a level last reached in 1982, according to data compiled by Bloomberg.
Bears say that valuations show that the United States remains in the slowdown that began in 2007.
By contrast to the Reagan era, when the Federal Reserve raised borrowing costs to as high as 20% to combat inflation, interest rates already are near zero, leaving policymakers fewer tools to boost the economy, bears contend. Bulls hold that the ratios are low because they reflect indiscriminate selling by investors convinced that any slowdown will turn into a repeat of the 2008 credit crisis.
“There are truly some terrific values out there in companies, but it's a question of timing,” said John Massey, a fund manager who helps oversee $13 billion at SunAmerica Asset Management Corp.
“Right now, the market is very short-term-sighted,” he said. “Every day, the market is up or down, and it's much more of a macro call than anything else.”
$2.3 TRILLION DROP
As of last week, about $2.3 trillion had been erased from the market value of U.S. equities since the S&P 500's recent high July 22, soon followed by reports on housing and manufacturing that trailed estimates, the worsening of Europe's debt crisis and Standard & Poor's decision to downgrade the United States' AAA credit rating. The last time that stocks in the index were cheaper on average during a recession was the early 1980s, a decade when the index surged 227% — 403% including reinvested dividends.
PRICE-EARNINGS
At the Aug. 26 close of 1,176.8, the S&P 500 traded at 10.8 times analysts' forecast for profits in the next 12 months of $109.12 a share. For the price-earnings ratio to reach its five-decade average of 16.4 without shares appreciating, earnings will have to fall to about $71.76 a share, 22% below that from 12 months' previous, data compiled by Bloomberg show.
Should companies meet analysts' profit estimates, the S&P 500 must advance to about 1,790 to trade at the average multiple of 16.4 since 1954, according to data compiled by Bloomberg. That is nearly 50% above where the index is trading.
WORST PERFORMERS
Energy, financial and industrial companies performed worst out of 10 groups in the S&P 500 in the past month, falling more than 15% as investors fled so-called cyclical stocks, which are most tied to economic growth. Utilities and makers of household products posted the smallest losses.
The index rallied 1.5% on Aug. 26 for its first weekly gain since July after Fed Chairman Ben S. Bernanke said during a speech that the economy isn't deteriorating enough to warrant any immediate stimulus. Optimism that the United States will avoid a recession helped offset a Commerce Department report showing that gross domestic product climbed 1% in the second quarter, missing a 1.3% estimate.
The economy grew at a 0.4% annual pace in the first quarter, the slowest since the second quarter of 2009, when the recession had yet to end, according to data compiled by the National Bureau of Economic Research.
REAGAN INFLATION
Runaway inflation at the start of Mr. Reagan's presidency in 1981 spurred the Fed, under Paul Volcker, to lift the federal funds rate, pushing the U.S. economy into a recession that lasted until November 1982. The S&P 500's multiple sank to an average of eight times earnings as record-high interest rates and 10-year Treasury yields above 15% reduced the appeal of equities.
Rates dropped over the next decade, helping fuel the equity rally.
Under Mr. Bernanke, the Fed has held the target rate for overnight loans between banks near zero since December 2008 and pledged last month to keep it there through mid-2013.
“The Fed's used up a lot of their big ammunition already,” said Bruce Bittles, who helps oversee $85 billion as chief investment strategist at Robert W. Baird & Co. Inc. “With earnings expectations coming down, P/E ratios are likely to remain lower than anticipated, as well.”
CHEAPER VALUATIONS
During the credit crisis, the world's largest economy shrank the most in any recession since the 1930s, according to the Commerce Department. Quarterly earnings among S&P 500 companies have almost doubled since ending an eight-period decline in September 2009.
Valuations declined as stock prices advanced at a slower rate, with the index climbing 11% since Sept. 30, 2009, data compiled by Bloomberg show.
For TCW Group Inc.'s Komal Sri-Kumar, valuations must be lower to be attractive because the economy is stagnating. The S&P 500 has declined about 10% since the start of June, the last month of the Fed's second program of quantitative easing, known as QE2, data compiled by Bloomberg show.
“Stocks have been at very high levels, compared with a very weak economy,” said Mr. Sri-Kumar, the chief global strategist at TCW, which oversees about $120 billion. “When QE2 was introduced last August [2010], you got a rally in equities prices for several months, but you didn't get a big push up in economic growth.”
Mr. Sri-Kumar recommended defensive stocks in the consumer staples, utility and health care sectors.
CONSUMER PRODUCTS
Shares of Procter & Gamble Co. (PG) have slipped about 2.6% since July 26.
This month, the world's largest consumer products company said that fiscal 2011 revenue topped analysts' estimates, and it reported a 15% increase in fourth-quarter profit on sales from emerging markets.
For Howard Ward, a portfolio manager at Gamco Investors Inc., the decline in valuations will prove temporary as investors buy back shares they sold in a panic after the S&P downgrade of the nation's credit.
General Electric Co. (GE) fell about 15% in the first two quarters, even after reporting profits that topped analysts' estimates. Its chairman and chief executive, Jeffrey R. Immelt, said in July that industrial earnings and sales should increase in the second half this year and accelerate into 2012.
Although analysts estimate that profit at the company will jump 21% this year, shares are trading at their lowest valuation since 2009.
MARKET DECLINE
“Too much has been read into the stock market's decline,” Mr. Ward, who helps oversee $35 billion, wrote in an Aug. 24 e-mail.
Corporate earnings are growing fast enough to boost equities, he wrote.
Per-share profit at S&P 500 companies will rise 13% next year, the fourth straight year of increases, according to analyst estimates compiled by Bloomberg.
Alcoa Inc. (AA), the country's largest aluminum producer, and Caterpillar Inc. (CAT), the world's biggest maker of construction and mining equipment, were among the worst performers in the Dow Jones Industrial Average last month, falling 25% and 19%, respectively, through Aug. 26. Analysts estimate that earnings will jump 21% next year at Alcoa and 33% at Caterpillar.
“The market's anticipating economic growth will slow and earnings estimates are going to have to come lower,” said Mark Bronzo, who helps manage $26 billion at Security Global Investors LLC.
“My gut is, the stock market is attractive at these levels and we won't go into a recession,” he said. “We'll be in a sluggish growth environment and eventually stocks will do better.”
