Investors are paying less for equities than they have during every recession since Ronald Reagan was president amid growing concern that the economy is on the edge of another recession.
The Standard & Poor’s 500 Index has lost 13 percent in the past five weeks, sending its price-earnings ratio down to 12.9. That’s 3.5 percent 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 valuations show the U.S. remains in the slowdown that began in 2007. Unlike under Reagan, when U.S. Federal Reserve Chairman Paul Volcker raised borrowing costs as high as 20 percent to combat inflation, interest rates are already near zero, leaving policy makers fewer tools to boost the economy, they say. Bulls say the ratios are so 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,” John Massey, a Jersey City, New Jersey-based fund manager who helps oversee $13 billion at SunAmerica Asset Management, said in a telephone interview on Aug. 26. “Right now, the market is very short-term sighted. Every day the market is up or down, and it’s much more of a macro call than anything else.”
$2.3 Trillion Drop
About $2.3 trillion has been erased from the market value of U.S. equities since the S&P 500’s recent high on July 22 after reports on housing and manufacturing trailed estimates, Europe’s debt crisis worsened and S&P stripped the U.S. of its AAA credit rating. The last time stocks in the index were cheaper on average during a recession was the early 1980s, a decade when the index surged 227 percent, or 403 percent including reinvested dividends.
At 1,176.80, the S&P 500 is trading at 10.8 times analysts’ forecast for profits in the next 12 months of $109.12 a share. For the P/E ratio to reach its five-decade average of 16.4 without shares appreciating, earnings would have to fall to about $71.76 a share, 22 percent below the last 12 months, 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’s more than 50 percent above its last close. Futures on the S&P 500 expiring next month gained 1 percent to 1,185.9 at 7:48 a.m. in London today.
Energy, financial and industrial companies have performed worst out of 10 groups in the S&P 500 in the past month, falling more than 16 percent, as investors fled so-called cyclical stocks that are most tied to economic growth. Utilities and makers of household products posted the smallest losses.
The index rallied 1.5 percent on Aug. 26, for the first weekly gain since July, after Fed Chairman Ben S. Bernanke said Aug. 26 during a speech in Jackson Hole, Wyoming, that the economy isn’t deteriorating enough to warrant any immediate stimulus. Optimism the U.S. will avoid a recession helped offset a Commerce Department report showing gross domestic product climbed at 1 percent in the second quarter, down from a 1.3 percent estimate.
The economy grew at a 0.4 percent annual pace in the first quarter of 2011, 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.
Runaway inflation at the start of Reagan’s presidency in 1981 spurred Volcker to lift the Fed funds rate, pushing the U.S. economy into a recession until November 1982. The S&P 500’s multiple sank to an average of 8 times earnings as record-high interest rates and 10-year Treasury yields above 15 percent reduced the appeal of equities. Rates dropped through the decade, helping fuel the equity rally.
Bernanke has held the target rate for overnight loans between banks near zero since December 2008 and pledged this month to keep it there through mid-2013.
“The Fed’s used up a lot of their big ammunition already,” Bruce Bittles, who helps oversee $85 billion as chief investment strategist at Milwaukee-based Robert W. Baird & Co., said in an Aug. 26 phone interview. “With earnings expectations coming down, P/E ratios are likely to remain lower than anticipated as well.”
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 the stock prices advanced at a slower rate, with the index climbing 11 percent 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 10 percent 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,” Sri-Kumar, the chief global strategist at TCW, which oversees about $120 billion, said in a phone interview on Aug. 24. “When QE2 was introduced last August, you got a rally in equities prices for several months, but you didn’t get a big push up in economic growth.”
Sri-Kumar recommended defensive stocks in the consumer staples, utility and health-care industries.
Procter & Gamble Co. (PG), the Cincinnati-based maker of Gillette razors, has slipped 2.6 percent since July 26, compared with a 13 percent decline by the S&P 500. This month, the world’s largest consumer-products company said 2011 revenue topped analysts’ estimates and reported a 15 percent increase in fourth-quarter profit on sales from emerging markets.
For Blackstone Group LP’s Byron Wien and Gamco Investors Inc.’s Howard Ward, the decline in valuations will prove temporary as investors buy back shares they sold in a panic after the U.S. lost its AAA credit rating at S&P.
General Electric Co. (GE) has fallen 15 percent this year even after reporting profits that topped analysts’ estimates in the first two quarters. CEO Jeff Immelt said last month that industrial earnings and sales should increase in the second half of 2011 and accelerate into 2012. While analysts estimate profit at the Fairfield, Connecticut-based company will jump 21 percent this year, shares are trading at their lowest valuation since 2009.
“Too much has been read into the stock market’s decline,” Ward, who helps oversee $35 million in Rye, New York, wrote in an Aug. 24 e-mail.
Corporate earnings are growing fast enough to boost equities, he said. Per-share profit at S&P 500 companies will rise 13 percent in 2012, 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 in the last month, falling 25 percent and 19 percent through Aug. 26, respectively. Analysts estimate earnings will jump 21 percent in 2012 at New York-based Alcoa and 33 percent at Peoria, Illinois-based Caterpillar.
“The market’s anticipating economic growth will slow and earnings estimates are going to have to come lower,” Mark Bronzo, who helps manage $26 billion at Security Global Investors in Irvington, New York, said in a telephone interview on Aug. 24. “My gut is the stock market is attractive at these levels and we won’t go into a recession. We’ll be in a sluggish growth environment and eventually stocks will do better.”