After Big Run, Stocks Are No Longer A Steal

P/E Ratios Suggest Caution Is In Order; A Complicated Choice By TOM LAURICELLA The outlook for stocks has brightened, but thanks to the big rally of the past two months, the market is no longer a bargain. By many measures, stocks are still on the cheaper side of the ledger. But they are approaching levels that bring them closer to long-term averages, making them neither a deal nor expensive. As a result, valuation has shifted from being a talking point of the bulls to one used by those bearish on the near-term outlook. And even many of those who think the market has hit bottom -- a rapidly growing group -- say valuations now suggest investors should tread more carefully. "The market is a little bit extended," says stock-market strategist Subodh Kumar, of Subodh Kumar & Associates. "Where it goes from here is going to depend on how quickly things really improve as opposed to getting less bad." For now, the "less bad" news has been enough for stock investors. Last week, the U.S. government's much-ballyhooed stress tests showed a number of the country's biggest banks needed capital, but in largely manageable amounts. April chain stores sales were better than expected, reinforcing the idea that the bulk of the pullback in consumer spending is over. And Friday's employment report suggested that while companies continue to slash jobs, the pace of the cuts is slowing. On balance, first-quarter earnings had enough positive surprises to cheer investors. All this has enabled stocks to extend gains that began from 12-year lows hit on March 9. With a solid rally Friday that capped the eighth up week out of the last nine, the Dow Jones Industrial Average has climbed 31% in the past two months and the Standard & Poor's 500-stock index is up 37%. While the rebound was a relief for battered stock investors, it complicated matters for those still trying to decide whether to get in or add new holdings. Higher prices have made stocks less of a screaming buy by several valuation measures. For example, based on the last 12 months of operating earnings, the S&P 500 was changing hands late last week at a price-to-earnings ratio of 14.7, according to Morgan Stanley. That's still below the average trailing P/E of 17 for the last 25 years but up sharply from 10.5 in February. Looking ahead to expected earnings for the next year, the story is less compelling for buying stocks. The S&P 500 was at a P/E of 14.5 late last week compared with a 25-year average of 15, according to the Morgan Stanley data. But many investors are reluctant to put too much weight on the forward P/E ratio during a period of significant uncertainty about the earnings outlook. Last October and November, for example, the S&P 500 appeared to be extremely cheap on that basis, trading below a P/E of 11. But it turned out that analysts had wildly overestimated the earnings for the year ahead. Analysts had forecast 2009 S&P 500 operating earnings of $89 a share; that's now down to $57. But for 2010, the consensus calls for an almost 30% rebound. Many investors also take issue with basing valuations against even historical earnings posted through the middle part of this decade. Profits from the period of record earnings growth that lasted into 2007 are now widely seen as having been significantly inflated by the credit and housing bubble. At the same time, the subsequent collapse of the economy sent earnings tumbling to low levels that also are seen as extreme. Already that's in evidence by the jump in S&P 500 operating earnings from their worst performance ever -- a nine-cent-a-share loss in the fourth quarter of 2008 -- to a first-quarter earnings increase that appears on track to hit nearly $10 a share, according to data from Standard & Poor's. And current as-reported earnings, which don't exclude one-time charge-offs, are creating readings seen as distorted. At the start of this month, the S&P 500 was at a P/E of 131 on that metric, according to Ned Davis Research. That's a record high that dwarfs the long-term average just south of 20. In this environment, valuation measures that compare stocks to longer-run earnings trends gain favor because they smooth out the cyclical peaks and valleys. Probably the most widely followed of these barometers, often known as "normalized" earnings, is the one created by Yale University professor Robert Shiller. He compares stock prices to a 10-year trend in earnings adjusted for inflation. In March, his normalized P/E ratio dropped toward 13, its lowest since 1986. Now, however, the measure is close to the historical average, with a reading of 15.9 at last Wednesday's close of 920 for the S&P 500. That's a reading that suggests "average returns for the next ten years," Mr. Shiller says. "However, I still think the market is risky right now." Ed Clissold, senior global analyst at Ned Davis Research, says that using Mr. Shiller's method, along with another measurement his firm creates by taking the median operating earnings of S&P 500 companies, valuations are "roughly in line with historical averages." "The market was modestly undervalued early this year -- enough to warrant a cyclical bull market. But valuations did not get to levels seen in previous secular bear markets," the most recent of which ended in 1982, Mr. Clissold says. In addition to profit levels, another important valuation variable for stocks is the outlook for inflation and interest rates. Historically, stocks have commanded higher multiples during periods of low inflation because investors are more willing to pay for earnings growth generated by a company's actual business activity rather than gains that reflect inflation. Ed Easterling, founder of Crestmont Research, says that while normalized P/Es may be average, "today's P/E is low compared to historical periods of low inflation." Mr. Easterling uses a variation of Mr. Shiller's approach that puts the S&P at a P/E of 14.9 compared with a historical average of 15. However, he says that in times where inflation has been between 1% and 2%, stocks have typically had multiples between 20 and 25. That would imply the S&P 500 should head toward 1200 or 1300. However, he says, he thinks the market is due for a pullback. "We've had quite a run, and the market doesn't run in a straight line," he says. Write to Tom Lauricella at tom.lauricella@wsj.com