Market numbers don't add up to lasting surge

VIEW FROM WALL STREET

September 01, 1991|By Thomas Easton | Thomas Easton,New York Bureau of The Sun

New York -- It was another sublime August on Wall Street, with share prices hitting new records and brokerage companies posting record profits. Were it not for layoffs throughout the rest of corporate America, innumerable bankruptcies and an inability -- in a pinch -- to sell their own homes, stock traders might be excused for thinking the recession ended long ago.

But the current euphoria is unlikely to last. Historically, the market has been unable to sustain a surge if the corporate financial underpinnings are weak.

And the underpinnings have not looked strong recently. Stock prices have risen far faster than profits, retained earnings, dividends or any other common statistical barometer of value. "By any standard measure, the market is high," said Eric Miller, chief investment officer for Donaldson, Lufkin & Jenrette.

No law, of course, prevents an already-high market from rising further. Given a boost in innovation or genius, even the most highly priced company is a good buy. Many pundits remain optimistic, suggesting that the rebound from a recession, a better "world order" and other trends are more important than current valuations. A Dow of 3,300 -- or even 5,000 -- has been mentioned by analysts considered to be of sound mind.

The market has already absorbed numerous disasters, including bank and insurance company failures, financial scandals, a municipal default and a persistent federal budget deficit, notes Mr. Miller. What dire event is left to trigger a panic?

Still, at current prices, some sort of decline is possible. The numbers suggesting that the market is overvalued are unforgiving.

Statistical compilations by Ned Davis Research of Nokomis, Fla., conclude that the share price of the 30 companies comprising the Dow Jones industrial average has, on average, been 1.57 times their book value (their assets minus liabilities). Currently, the price exceeds 2.2 times book value. The disparity is even more extreme when the benchmark used is the Standard & Poor's 400. Davis Research concludes that the average price has been 1.61 times book value; the current price is almost 2.9 times book value.

That has prompted institutional investors who care about book jTC value to largely shun the market. "The price-to-book value ratio is as high as it was in 1929, 1987 and 1989," said Richard Fontaine, a Baltimore-based fund manager. "All those times it's been a time to sell, not to buy, and we don't think this time is any different."

The relationship of dividends to stock prices is not as extreme. But it's still above normal levels. Davis Research, drawing on figures dating back to 1916, reckons that the Dow Jones industrial average has sold at an average of about 23 times dividends, a number that would put the Dow at about 2,250 or 2,300, rather than the 3,000 it is today.

Typically, said Lance Stonecypher of Davis Research, bull markets peak with the Dow at 29 times dividends. Currently, it stands at about 30 or 31 times dividends.

The last measure most commonly used is the ratio of price to earnings. Again, that shows the market to be high. Using the prior 12-month profits, the Dow is now priced at about 16.7 times earnings, compared to a high of about 20.5 at the peak before the October 1987 crash, or a low of 5.8 in 1974, when the market was at its quarter-century trough.

Because companies are valuable because of the profits they will produce -- rather than those they already have produced -- analysts often compare share prices to expected earnings. And that adjustment may explain why some people expect the stock market to continue climbing.

A compilation of 2,500 analyst forecasts by the Institutional Brokers Estimate Service shows that profits for U.S. companies are expected to surge 27 percent in 1992. That's more than double the average forecast. While these estimates typically are too optimistic, said Richard Pucci, IBES research director, it is still an important signal.

"Although you could probably win a bet that 27 percent won't be the number, it is significant for its magnitude and direction," Mr. Pucci said. Only three times in the 1980s was the number so large -- 1983, 1984 and 1988. All three saw growth in profits of more than 15 percent.

For investors who try to buy stocks at cyclical market peaks and to sell at low spots, recent times have been trying.

"There aren't a lot of stocks meeting our requirements," said James Rea, a portfolio manager with the Rea-Graham Balanced Fund, whose strict investment guidelines were established by Benjamin Graham, the Columbia Business School finance professor who is often credited with inventing modern securities' analysis. "Everybody has been very euphoric, but based on historic norms, the market is high. We're very patient. We're waiting for bargains."

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