Are stocks worth buying now?
With the Dow Jones Industrial Average breaking through 15,000, it’s natural to worry that stocks have gone up too far. But higher-priced stocks aren’t necessarily overpriced. They may still be a good deal if corporate earnings are rising fast and you think that trend is likely to continue.
A solid April jobs report on Friday is a sign the economy is strengthening. That could lead to higher profits. What’s more, many of the traditional threats to bull markets — rising inflation and interest rates, a possible recession — don’t seem likely soon.
That said, stocks are no bargain. Buy them only if you’re willing to ride the inevitable ups and downs and hold on for a while.
A look at some forces that could push stocks higher in the coming months:
- HIGHER EARNINGS: Stock investors cheered when employers added 165,000 jobs in April and unemployment fell to a four-year low. More people working means more money flowing into the economy. That could help companies extend a remarkable streak of ever-higher profits.
Companies in the Standard & Poor’s 500 index posted a record $102.83 earnings per share last year, or 17 percent higher than in 2007, when stocks were last near this level, before the financial crisis.
How do stock prices compare with those earnings?
To answer that, experts look at what’s called price-earnings ratios, or P/Es. Low P/Es signal that stocks are cheap relative to a company’s earnings; high ones signal they are expensive.
P/Es are calculated by dividing the price of each share by annual earnings per share. So a $100 stock of a company that earns $10 per share trades at 10 times. The lower the P/E, the cheaper the stock.
There are various P/Es. Some use past earnings and other future earnings. They give a mixed picture, but together suggest that stocks are reasonably priced.
If you look at earnings from the past year, the S&P 500 is trading at 15.6. That is slightly lower, or cheaper, than the 17.2 average for this P/E since World War II, according to S&P Capital IQ.
Using forecast earnings for the next 12 months, you get a P/E of 14.2, the same as the average over 10 years, according to FactSet, a provider of financial data.
Another measure shows stocks are somewhat expensive, however.
Some investors think you should look at annual earnings averaged over 10 years instead of just one year. This eliminates any surge or fall due to changes in the business cycle. Dividing stock prices by a 10-year average of earnings yields a P/E of 23 times. That is higher, or more expensive, than the average 18.3 since WWII.
A word of warning: You shouldn’t invest just by looking at P/Es. They are not perfectly reliable, and should be used only as a guide. There have been long periods when stocks traded at lower or higher P/Es than the averages.
- ECONOMIC EXPANSION: With Friday’s jobs report, the odds for continued expansion got better. The economy has created an average of 208,000 jobs a month from November through April, above the 138,000 average for the previous six months.
The report follows news that the pace of economic growth picked up in the first three months of this year, home prices rose at the fastest pace in nearly seven years and automakers had their highest sales for April since the recession.
Tally it up, and financial analysts see earnings for the S&P 500 rising 12 percent in the last three months of the year, a big jump from an estimated 4.8 percent gain in the first three months.
There’s plenty of reason for caution, though.
For starters, analysts tend to overestimate earnings several quarters in the future, and may be doing that again. Early last year, they expected a 13 percent jump in earnings in the last three months of the year. They got 4 percent instead.
And some experts believe Wall Street is underestimating how much the sweeping federal spending cuts that kicked in March 1 are going to slow the economy, as government workers are furloughed and contractors lose business. If they’re right, that could erode earnings.
Investors also have to keep an eye overseas. Half of revenues at big U.S. companies are abroad, and some key economies are slowing or contracting. This can hit stocks hard, as General Electric shows.
Last month, when GE reported a 17 percent fall in revenue from Europe, its stock dropped 4 percent in a day. Many European countries are mired in recession, and the outlook has only gotten worse. Unemployment in the eurozone just rose to an all-time high of 12.1 percent.
China has put investors on edge, too. On April 15, news that it grew more slowly than expected in the first three months of this year helped push the Dow down 266 points, the biggest drop for the year.
One thing to keep in mind is that big, sustained drops in stocks — ones that end bull markets — are most often caused by U.S. recessions, and that doesn’t appear likely soon.
Four of the past five bull markets ended as investors dumped stocks before the start of a recession. They sold stocks two months before the start of the Great Recession in December 2007, and a year before the March 2001 recession.
The U.S. economy has grown between 1 and 2.5 percent in the past three years. That’s pitiful compared with the long-term average of 3 percent. Still, it’s growth.
- LOW INTEREST RATES: If recessions cause stocks to plummet, what causes recessions? In most cases, it’s the Federal Reserve raising short-term interest rates because it fears high inflation from an overheated economy. Fed hikes were the trigger for three of the past four recessions.
But today, the greater fear is too little inflation, not too much. The Fed’s preferred measure of inflation rose only 1 percent in the year through March. The Fed’s target is 2 percent.
What’s more, the Fed has said it would keep key short-term rates nearly zero until unemployment falls to at least 6.5 percent. It is 7.5 percent now.