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Cheap stocks? Maybe not Add to ...

If you accept Monday’s Bloomberg News article on stock market valuation, you will likely feel the impulse to dive headfirst into stocks after their recent bout of weakness. But as any swim instructor will tell you, it is always a good idea to inspect unfamiliar water before taking a deep plunge.

Bloomberg tells us that the S&P 500 is cheaper today than it has been in decades. By this, they mean that the current price-to-earnings ratio is low next to valuations seen during other bull markets.

More specifically, the index is “below the ending level of eight of the nine bull markets since 1962.” It would have to rally an impressive 26 per cent to reach the valuations of those earlier bull markets. To look at it another way, the price-to-earnings ratio hasn’t risen above 16 over the past two-and-a-half years, versus an average of 17.4 during other bull markets.

“The stock market looks cheap because people are way too pessimistic about what growth looks like for the next 10 years,” Brian Jacobsen, chief strategist at Wells Fargo Advantage Funds, told Bloomberg. He expects the S&P 500 will rise to a record high of 2,000 in 2014, marking an impressive 44 per cent rally from the current level on Tuesday.

Mr. Jacobsen is particularly bullish. But even the average strategist, among those tracked by Bloomberg, sees the S&P 500 rising to 1585 by the end of 2013, or more than 14 per cent.

But are stocks really such a deal right now? Earnings suggest otherwise. While it is true that companies within the S&P 500 managed, yet again, to top analysts’ expectations in the third quarter – with 65 per cent beating estimates – that’s only because estimates have been slashed.

According to Thomson Reuters (via MarketWatch), blended earnings were flat in the third quarter over last year, while revenues slid 0.8 per cent. According to FactSet, earnings fell 0.2 per cent while revenues fell 1.2 per cent.

S&P 500 operating earnings, which take extraordinary items into account, are also struggling amid weak economic growth and uncertainty over the looming U.S. fiscal cliff of automatic tax increases and spending cuts. These earnings are set to fall to $24.35 (U.S.) a share, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. That’s down 4.2 per cent from the second quarter.

“Q3 looks like the start of a decline,” Mr. Silverblatt told MarketWatch.

If he’s right, the S&P 500 might not look like the best buying opportunity right now – and its slight decline since mid-September hardly changes that impression.

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