Buying Stocks Now May Be Less Risky Than You Think

Is it too late?

If you’ve stayed out of stocks recently, you might be worried that you’ve missed your chance to get back in. After all, they must be expensive, now that the Dow Jones industrial average has risen 120 percent in four years to a record high.

The good news is that stocks still seem a good bet, despite the run-up. The bad news: They’re no bargain, at least by some measures, so don’t get too excited.

Many investors obsess about stock prices. But you must give equal weight to a company’s earnings. When earnings rise, stocks become more valuable — and their prices usually rise, too. That’s what seems to be happening now.

“We’ve had record profits upon record profits,” says John Butters, senior earnings analyst at FactSet, a research firm. “And estimates are, we’ll have record profits this year, too.”

What’s more, some of the typical threats to stock run-ups , including rising inflation and interest rates, which often trigger a recession , seem unlikely to appear soon.

Among reasons to consider stocks again:

A Stronger Economy:

There are no signs of a recession. And that’s encouraging for stocks, which almost always fall ahead of an economic downturn. Stocks started falling two months before the Great Recession began in December 2007, and one year before the recession that started in March 2001.

Better yet, the economy may be on the verge of faster growth. The Labor Department announced Friday that the unemployment rate in February dipped from 7.9 percent to 7.7 percent, its lowest level since December 2008. Employers added more than 200,000 jobs each month from November-February, compared with 150,000 in each of the prior three months.

More jobs mean more money for people to spend, and consumer spending drives 70 percent of economic activity.

There has been a flurry of other hopeful signs lately. Homebuilders broke ground on new homes last year at the fastest pace in four years. Sales of autos, the second-biggest consumer purchase, are at a five-year high.

If recent history is any guide, this economic expansion is still young. The expansion that began in June 2009 is 44 months old. The previous three expansions lasted 73 months, 120 months and 92 months, respectively.  Corporate earnings grow during expansions, which can push stocks higher.

In the 1982-1990 expansion, earnings of companies in the Standard and Poor’s 500 stock index grew 50 percent, according to S&P Dow Jones Indices, which oversees the index. The S&P 500 itself surged nearly 170 percent.

For 2013, earnings of S&P 500 companies are expected to grow 7.9 percent, then jump another 11.5 percent next year, according to FactSet. If that expectation proves correct, stocks could rise fast.

But history offers three caveats: First, if you look at the 11 expansions between World War II and the present, instead of only the last three, they lasted 59 months on average. By that measure, the current expansion is middle aged, not young.

Second, investing based on U.S. economic expansions may not work as well as in the past. Big U.S. companies generate nearly half their revenue from overseas now, so you need to worry about other economies, as well. The 17 European countries that use the euro as a currency have been in recession for more than a year. Japan, the world’s third largest economy, has struggled to grow.

If the worst is over for these countries, U.S. stocks could continue rising. If growth drags, stocks could fall.

Third, earnings forecasts are often too high. They come from financial analysts who study companies and advise on which stocks to buy. In the past 15 years, their annual earnings forecasts were an average 10 percent higher than actual outcomes, according to FactSet. Last year, they got closer, overestimating by 4 percent.

Stocks Reasonably Priced:

Investors like to use a gauge called  the price-earnings ratio in deciding whether to buy or sell. Low P/E ratios signal that stocks are cheap, relative to a company’s earnings; high ones signal they are expensive.

Right now, P/E’s are neither low nor high, suggesting stocks are reasonably priced.

To calculate a P/E, divide the price of a stock by its annual earnings per share. A company that earns $4 a share and has a $60 stock has a P/E of 15. Most investors calculate P/E’s two ways: based on estimates of earnings in the next 12 months, and on earnings during the past 12.

Stocks in the S&P 500 are at 13.7 times estimated earnings per share in 2013. That is close to the average estimated P/E ratio of 14.2 over the past ten years, according to FactSet. The P/E based on past earnings paints a similar picture. The S&P 500 trades now at 17.6 times earnings per share in 2012, basically the same as the 17.5 average since World War II, according to S&P Dow Jones Indices, which oversees the index.

Again, a caveat.

Another way to calculate P/E’s, called a “cyclically adjusted” ratio, suggests stocks are not such a decent deal. Its champion is economist Robert Shiller of Yale University, who warned about the dot-com and housing bubbles. Shiller believes it’s misleading to look at just one year, because earnings can surge or drop with the economic cycle. To smooth such distortions, he looks at annual earnings per share averaged over the prior 10 years.

The cyclically adjusted ratio is 23 times. Since the end of World War II, it’s ranged between 6.6 and 44.2, and the average is 18.3. That suggests stocks are expensive, though perhaps not wildly so.

No matter which P/E you choose, it’s important to think of it as a rough guide at best. Stocks can trade above or below their average P/E’s for years.

Optimistic Investors:

A new love of stocks could prove a powerful force, pushing prices up. In fact, it can push them up even if earnings don’t increase.

That’s what happened in the five years concluding at the end of  1986. Earnings fell 2 percent, but the S&P 500 almost doubled as small investors who had soured on stocks throughout the 1970s returned to the market. The multiple — shorthand for price-earnings ratio — rose from eight to nearly 17. Market watchers refer to this as “multiple expansion.” Will it happen again?

As stocks have surged over the past four years, individual investors have been selling, a nearly unprecedented phenomenon in a bull market. But they might be having second thoughts. In January, they put nearly $20 billion more into U.S. stock mutual funds than they took out, according to the Investment Company Institute, a trade group for funds.

Some financial analysts say we are at the start of a “Great Rotation.” That would mean investors shifting money into stocks from bonds. If that happens, stocks could soar. It’s too soon, however, to say if the buying will continue.

Howard Silverblatt, senior index analyst at S&P Dow Jones, thinks investors are too worried about the future of the euro and government spending cuts to dive into stocks as they did in the 1990s.

“We don’t have a lot of confidence going forward, so people are limiting what they’re willing to wager,” he says.

Low Interest Rates:

Interest rates are near record lows. That’s good for stocks, since it lowers borrowing costs for companies and makes bonds, which compete with stocks for investor money, less appealing.

If you want to kill a stock rally, hike interest rates.

That’s what happened in the run-up to Black Monday, Oct. 19, 1987. In August of that year, the yield on the 30-year Treasury bond rose above 10 percent. Investors thought, “If I could make 10 percent each year for 30 years in bonds, why keep my money in stocks?” Consequently, they sold, and stocks drifted lower. Then Black Monday struck. The Dow plunged 508 points, or nearly 23 percent — its largest fall in a single day.

Today, the yield on the 30-year Treasury bond is 3.2 percent. The yield on the 10-year Treasury note is 2.05 percent, less than half its 20-year average of 4.7 percent. It could be years before rates return to that average level.

Of course, interest rates could jump, based  on fears of higher inflation. But inflation has been 1.6 percent the past year, below the Federal Reserve’s 2 percent target. What’s more, the Federal Reserve  has promised to keep the benchmark rate it controls near zero, until unemployment falls to 6.5 percent.  The unemployment rate  today is 7.7 percent.