Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Stocks May Not Be as Cheap as Many Pros Think

Stocks may look like a bargain now in terms of the price-to-earnings ratio, but if corporate profits start weakening, they may not look so inexpensive.

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The main driver in the stocks-are-cheap mantra is that the Standard & Poor’s 500 has a P/E ratio of just over 14, which is below the historical average near 16.

In plain language, that means the average stock in the S&P 500 is trading 14 times higher than its annual per-share net profit.

But should the denominator—the earnings number—start coming down, that would send that P/E figure higher and suddenly make that share price not seem like such a discount after all.

For instance, if Company A is trading at $20 and has earnings of $4 a share, its P/E is 5. But should that earnings number drop to $2 a share, the P/E suddenly shoots up to 10 and makes the stock seem costly.

Revised estimates for publicly traded companies suggest strongly that while such a dramatic change as cited in the above example is unlikely, the trend for earnings is lower, likely making stocks appear more expensive.

Consensus earnings estimates for the Standard & Poor’s 500 have come down to a shade below $100 and are trending lower.

In the broader stock universe of the S&P 1500, analysts have lowered forecasts for 720 companies and raised them for 272, working out to a net of minus-448 or 29.9 percent of the index, the worst since April 2009, according to research from Bespoke Investment Group.

Four of the 10 S&P sectors have seen negative earnings revisions for at least 40 percent of their components.

“It’s hard to find much in the way of bright spots, as there are only four groups with positive net revisions ratios, and all of them are defensive in nature,” Bespoke said in an analysis.

Two industries classified as cyclical—which would be expected to lead in a market recovery—are especially negative, with a 67.7 percent negative revision for semiconductors and 70.4 percent for transportation.

“When more than two-thirds of all transportation stocks are seeing numbers cut, it seems safe to assume that analysts are pretty confident a recession is in the cards,” Bespoke wrote. “If there is any bright side to all this pessimism, it is that the bar is getting set exceptionally low. If companies fail to exceed these levels come October, it could be a long winter.”

Of course, the equalizer in terms of P/E ratios is that if earnings season—which kicks off in early October—is poor, then stocks would fall, lowering multiples but also signaling a recession.

Recent research from S&P suggests that a recession scenario actually would produce an S&P 500 P/E in the 12 to 13 range as the index plunges to a range of 900 to 1030.

Wells Fargo Securities was among the major forecasters recently to drop earnings estimates, projecting a full-year view for 2011 of an even more bearish $93.40 per share (from $94.40) on the S&P 500, and a drop from a previous forecast of $103.50 to $98.70 in 2012.

Gina Martin Adams, a senior analyst at the firm, said dysfunction in Washington is a good portion of the reason that Wells has taken its projected S&P 500 P/E down to 13.

“The gridlock witnessed from the debt ceiling debate portends a contentious climate regarding the Obama jobs bill, in our view, and the distractions of an election in 2012 will likely only add to problems emanating from Washington, ultimately increasing uncertainty and weighing on risk assets,” Adams wrote in a research note.

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