To P/E or Not to P/E

ATLANTIC HIGHLANDS, NJ – March – A look at the Dow industrials shows that the entire late-1990s bubble, not to mention the rally from 2003 to 2007, has been completely washed away. With the Dow closing below 7000 for the first time in more than 11 years, one can’t help but wonder, using traditional valuation metrics, whether stocks are finally falling to appropriate levels. It mightn’t be the right question to ask. “Valuation is the wrong concept in a secular bear market,” says John Mauldin, president of Millennium Wave Investments in Dallas. “If we continue to see earnings drop from forecasted levels, as we have for over a year, then it is possible we could see more pain. Valuation is subjective in such a climate. When earnings start to stabilize, and we can get some visibility, then we can talk about fair value.” The current market climate has drawn comparisons to the mid-1970s, when investors dreaded coming into work, knowing the markets were in for a rough time. With that kind of despair ruling the market, “what’s the difference between 12 times or eight times or 10 times earnings? There isn’t demand for equities, because people can’t see any signs of recovery soon,” says Peter Boockvar, equity market strategist at Miller Tabak. He contrasted this with the late 1990s, when “expensive got more expensive.” The problem, according to investors, is that S&P 500 earnings expectations are constantly changing, as analysts reduce their expectations for per-share earnings. As of a few weeks ago, analysts anticipated per-share operating earnings to come in around $69 in 2009, according to Thomson Reuters, but that figure (already reduced from some kind of previously ridiculous estimate) has come down in the last few weeks, and now the expectation is for earnings of about $50 to $55 a share for the year. Using a typical valuation at the market’s nadir — a price-to-earnings ratio of anywhere from eight to 12 times earnings — that puts the S&P 500, optimistically, at 660. It only broke through 700 Monday. So even a more optimistic outlook still suggests more pain. Market strategists, until recently, were quick to dismiss the consensus, knowing it was too high — but now they are concerned that even the reduced revisions mightn’t capture the depth of the economic decline. “The risk is to the downside if the economy substantially worsens from the levels we currently see,” says Fred Dickson, director of private client research at D.A. Davidson. “It’s a downward moving target at the moment, and the valuation metric has just been very tough to put one’s finger on.” By DAVID GAFFEN, WSJ