Stocks should be turning investors' heads

S&P 500

August 08, 2004|By JAY HANCOCK

WALL STREET is throwing a sale, and you probably didn't even know it.

It costs only $19 these days to buy $1 in proven profits thrown off by the big corporations in Standard & Poor's 500 index.

That's a milestone, the cheapest in more than seven years, but investors are focused on terrorism, oil and jobs. Maybe they're missing something.

Not long ago $1 in S&P 500 profits cost stock investors more than $50. (The same as saying the price-to-earnings ratio was over 50.)

Last month the S&P 500's price-to-earnings gauge dipped under 20 for the first time since March 1997, when Goldman Sachs seer Abby Joseph Cohen was proclaiming, "the U.S. bull market is intact."

What closed the gap? Growing economic pessimism, punctuated by Friday's terrible jobs report, has pushed the S&P 500 price down 8 percent since February, but that's only part of the action. The big reason stock prices and stock profits converged was an amazing earnings surge that began in 2002 and continued through June.

First-half 2004 corporate earnings "were gangbusters," says Joseph Quinlan, chief market strategist for Banc of America Capital Management.

Here's how gangbusters: When final results arrive, the quarter ending June 30 will probably mark only the fourth time in 50 years that S&P's 500 companies booked four consecutive quarters of profit growth exceeding 20 percent, figures Richard Cripps, chief market strategist for Baltimore's Legg Mason. The others were 1995, 1984 and 1975.

Earnings were so strong in this year's first quarter that 72 percent of the S&P 500's companies beat analysts' profit estimates.

"That's the highest we've ever seen," Cripps says.

And these were probably real profits, unlike the confections spun by Enron, WorldCom and the like. Prosecutions, the Sarbanes-Oxley Act and the toughest public scrutiny in decades should have vanquished the fraudsters.

Big-company stocks, which are more reasonably valued by several measures these days than smaller issues and technology shares, are also a better buy when you consider dividends.

The dividend yield on the S&P 500 is 1.8 percent, up from 1.1 percent in early 2000 and more than the annual interest on a six-month Treasury bill. Dividends may rise further, as cash-flush companies share profits with investors and take advantage of new tax laws favoring dividends.

Prudential Equity Group analyst Edward Yardeni likes to compare the values of U.S. stocks and Treasury bonds, which, after all, are simply two ways of generating income. Under Yardeni's formula, "the market remains incredibly cheap" when held up against the 10-year Treasury note, he wrote in a memo to clients last week.

Of course, sometimes there are reasons stocks are cheap. In this case, the stock market frets that the earnings spurt won't continue at the recent rate. And there are reasons to worry.

Three buoyant factors for corporate profits - tax cuts, lower interest rates and government spending jumps - are disappearing or losing influence. Three big anchors - oil prices, terrorism fears and lackluster job growth - hinder expectations.

And the American consumer is the No. 1 question mark. Much of the fabulous profit increases of the past year came not from better revenue but from worker abuse - cost-cutting and downsizing. That hurt consumer spending, which in turn held back revenue growth.

If corporate sales and hiring don't begin rising smartly soon, the economy and future profits are at risk, many analysts believe.

But even under diminished earnings projections, the big companies that make up the S&P 500 index seem relatively inexpensive. At Friday's close of 1,063, the S&P sells for 16 times estimated earnings for the next four quarters, close to an eight-year low. The average S&P 500 price-earnings ratio for the past 50 years is 17, Cripps says.

And corporations, burned by accusations that they hyped past profits, may be low-balling earnings guidance.

Banc of America Capital Management's Quinlan, who favors big, dividend-paying companies, believes such shares "are fairly priced now" and might partly sidestep a U.S. slump with overseas earnings. "They're not exactly cheap, he says. "But I think in many cases it's a good entry point."

Not exactly cheap, but cheaper than they've been in a while. Wall Street legend John Templeton always said to buy stocks at the moment of maximum pessimism. Are we there yet?

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