Stock Talk: Overvalued?
October 8, 2007
The S&P 500 Index ($SPX) set a new record last week and, for some market watchers, the new highs might seem somewhat unjustified. After all, the stock market faces a number of negatives including disappointing third quarter earnings, an uncertain interest rate outlook, as well as the potential for further economic fallout from the housing slump and mortgage loan debacle. In short, there are clearly some risks facing some investors, especially if the stock market’s recent run higher has stretched prices to where the stock market is now overvalued.
Indeed, the valuation question is one issue investors will be forced to consider heading into the third quarter earnings reporting season. Alcoa (AA) officially kicks things off. The aluminum maker is the first Dow component to report results for the quarter and will release results Tuesday after the close of trading. The floodgate doesn’t open until next week, however, when hundreds of companies are due to report. The action will then last throughout the remainder of October and into early November.
Overall, third quarter results are not expected to be stellar. According to Standard & Poor’s, analysts currently expect the members of the S&P 500 to post total operating earnings of $23.46 for the three month period ended September 2007. That, in turn, is up just 1.9% from the third quarter last year. So, third quarter growth is going to be anemic at best.
While total S&P 500 earnings are expected to show only modest improvement in the third quarter, the S&P 500 Index is up a respectable 9.8% so far this year and now setting record highs. The index’s price to earnings ratio, using the past four quarters as a guide, is 17.01. So, looking at the price to earnings ratio of the S&P 500’s along with the expected growth rate indicates that the market is overvalued to say the least. In other words, low single digit growth in earnings doesn’t justify an S&P 500 trading at 17 times operating earnings.
Yet, while third quarter earnings probably don’t justify the current valuations on the S&P 500, market bulls are looking beyond those results and at the potential for better earnings during the fourth quarter of 2007. According to Standard & Poor’s, analysts currently expect the members of the S&P 500 to post total earnings of $24.30 during the final three months of the year. If so, it would represent a 3.6% improvement over the third quarter and a 10.5% improvement from a year ago.
Moreover, if analysts are correct for the third and fourth quarter, total S&P 500 operating earnings in 2007 is likely to be roughly $94.20, which gives the S&P 500 Index a price-to-earnings ratio of 16.5. During a period of low inflation and low interest rates, a ratio of 16.5 might be justified. As a general rule, the yield on the S&P 500 should be roughly equal to the yield on the ten-year Treasury bond. Currently, the yield on the ten-year is 4.65%. With the index at 1,550, the earnings yield for the S&P 500 is 6% ($94.2/1,550). The earnings yield on the S&P 500 is currently 30% greater than the corresponding yield on the ten-year.
Another way to gauge overall market valuations is with a formula that looks at the expected earnings of the S&P 500 [which can be found at Standard & Poor’s web site, spglobal.com] and the ten-year yield. The formula takes the total expected earnings for the S&P 500 multiplied by the reciprocal of the yield on the ten-year. So, if the yield on the Ten-Year is now 4.65% and, according to Standard & Poor’s, the earnings for the entire S&P 500 in the four quarters ending December 2007, the formula is:
(1/.0465) x 94.2 = 21.50 x $94.20 = 2,025.
The math yields a value of 2,025 for the S&P 500. Therefore, with the Standard & Poor’s Index trading near 1,550, it is 30% undervalued according to this formula!
In conclusion, the outlook for the third quarter earnings reporting season isn’t very bright, but investors will want to focus more on what is going to be said about the fourth quarter and into 2008. By some measures, valuations are not stretched by any means. Therefore, even stable and steady earnings growth can continue to support higher prices. If so, the new highs in the S&P 500 set last week might indeed by justified and, unless there are dramatic revisions to the earnings outlook or the interest rate landscape, the stock market is probably not overvalued.
Frederic Ruffy
Senior Writer
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