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Archive for Sunday, October 9, 2005

Stock market seems less risky now than in years

October 9, 2005

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A friend of mine who is a savvy investor once made a comment about the stock market that didn't, at first, seem to make sense:

"If you're not retired, you WANT the market to do badly."

All he meant was that during the years you are plowing new money into investments, it's best if prices are low. Yes, you want the market to boom - but not until later, after you've got your investments in place.

This is worth remembering now that we're three-quarters of the way through 2005. The stock market's results are generally poor this year, but the future might be promising.

The Standard & Poor's 500 has returned just 1.23 percent since Dec. 31, the Dow Jones industrial average is down 2.29 percent and the Nasdaq Composite is off 1.46 percent.

But those numbers aren't the whole story.

Companies are about to start reporting their third-quarter results, and total earnings for the 500 companies in the S&P 500 index are expected to grow 16.2 percent over the same quarter last year, S&P said last week.

That would make the 14th straight quarter of double-digit earnings gains, a record.

Over time, earnings gains generally cause stock prices to go up a like amount. But that's not happening. What's this mean?

Basically, that investors have become conservative. What we see now is the opposite of what we saw in the late '90s. Back then, investors would bid share prices up even if there were no earnings at all. Now, even fat earnings gains don't seem to impress.

This is reflected in the price-to-earnings ratio, figured by dividing a stock's or index's current price by corporate earnings over the previous 12 months.

Historically, this figure has averaged about 15. Whenever it is higher, investors are paying more for every dollar of earnings, and there's a greater risk that stock prices will fall so that the P/E will return to the average.

When the S&P set its record high in March 2000, its P/E was about 30 - investors paid $30 to share in $1 worth of earnings. By the end of 2001, with earnings collapsing faster than share prices, the figure had gone to more than 46.

Currently, S&P says, the ratio is at 18.35. Investors are willing to pay only $18.35 for $1 in earnings. The ratio is at the lowest since the end of 1995 because earnings have soared and share prices have not.

By this measure, stocks are far less risky than they have been in a decade.

Of course, that doesn't mean there's no risk. If earnings were to stop growing, a return to the long-term average P/E of about 15 would require an 18 percent drop in share prices. And there have been times when the P/E was below 15.

Many experts, however, think the "norm" of 15 is out of date, given changes in factors such as tax rates, inflation and interest rates. Quite a few think the norm should now be around 20, or even a bit higher. If so, stocks are currently underpriced.

Regardless of whether that's the case, any continuation of healthy earnings gains is likely to result in higher stock prices sooner or later. S&P forecasts double-digit earnings growth for the fourth quarter of this year, and a 9 percent gain in the first three months of 2006.

Granted, there are lots of concerns. Consumers' vigorous spending has kept the economy going for years. But now consumer confidence is sagging and incomes are flat or dropping. With fuel prices very high, people may curb other spending.

Another source of spending money is cash pulled out of homes through mortgage refinancings. Rising home values and falling interest rates fueled that trend. Now mortgage rates seem to have bottomed, and there are signs home price gains are slowing. This source of spending money could shrink.

But even with all that, stocks do seem less risky than they've been for years. That's a very good sign - assuming you're in the market for the long run.

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