Tuesday, November 18, 2008

Stock Market Still Seems Too Sanguine

One truism about markets is this: No matter how pessimistic stock investors are, the bond markets are almost always more despairing. Since the market's swoon in mid-October, stocks have found a bit of a foundation, including in the 800s for the Standard & Poor's 500 index. But credit markets are unambiguously downbeat, as corporate-debt yields remain priced for economic gloom. Looking at the markets side by side, stocks are priced for a more-benign economic outcome. One way to measure that is by comparing corporate-bond yields to stocks' earnings "yield," or forecasted per-share earnings divided by stock prices. Under normal economic circumstances, the S&P 500 should yield about 85% of run-of-the-mill, Baa-rated corporate bonds (a low rating for a bond that is still classified as "investment grade"). When times are rough, the S&P 500's yield rises, generally to levels into line with or above those bond yields. Right now the S&P yields 10%, compared with about 9.5% for Baa-rated corporate bonds, if one uses the Thomson Reuters consensus estimate for 2009 S&P earnings of $87 a share. That should suggest stocks are a slight bargain. But many economists believe the earnings forecasts are at least 20% too high. Assuming a recession that hurts earnings as badly as did the 1981-82 recession, Michael Darda, chief economist at MKM Partners, says S&P earnings could fall to about $68 a share. At the S&P's current level, that translates to a yield of about 8%. A more attractive 10% yield would require the S&P falling to 680. Another Great Depression isn't likely, and bond yields could be too high, presenting what could be an opportunity for bond investors. Those markets could improve. But stock prices still seem too high; the recent bottom in that market might be eclipsed. Cure for Deflation? The Printing Press Lower prices are a good thing for economies, right? Not if they bring on deflation. The producer-price index, a key measure of wholesale inflation in the U.S. due for release Tuesday from the Labor Department, is expected to show a decline of 1.7% in October, bringing inflation closer to the Fed's comfort zone. Treasury inflation-protected securities, bonds used as a hedge against changing prices, currently are pricing in consumer-price inflation at an average of 1% for the next 10 years, according to Barclays Capital. That is dangerously close to the zero-price growth that demarcates deflation. Economists appear less worried than markets about falling prices. They maintain that the proactive stance of the Federal Reserve and other central banks will head off deflation. Comments from current Federal Reserve Chairman Ben Bernanke years before he was Fed chief offer support for economists' arguments. In his famous address on fighting deflation in 2002, Mr. Bernanke said the Fed wouldn't run out of ammunition to influence prices, even after cutting interest rates to zero: "The U.S. government has a technology, called a printing press ... that allows it to produce as many U.S. dollars as it wishes at essentially no cost," he said.

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