Are stocks getting too risky?

If there were a definitive answer, it would have to be “no.” The instant stocks edged into risky territory, investors would spot it and pull back. Lower demand would flatten prices, and risk would automatically drop to acceptable levels.

The problem is, there is no perfect way to gauge risk, since we can’t predict the future. So stocks do go through periods of excessive risk – and occasionally through bubbles like the one from which we are still recovering.

In the absence of perfect risk gauges, investors turn to imperfect ones, such as the P/E ratio. That’s figured by dividing a stock’s price by the company’s earnings over the previous 12 months.

If the stock price is $10 and the company had earned $1 a share, the P/E would be 10 – the $10 divided by $1. In effect, shareholders would be earning 10 percent on their investment – $1 in earnings for every $10 tied up in the stock. Today, that would be pretty good compared to what they’d get in bonds or bank accounts.

If the share price rose to $50 and earnings held at $1, the P/E would be 50. The investor would be earning just 2 percent – $1 for every $50 tied up in the stock. Since lots of other investments can compete with 2 percent, investors could easily lose interest in the stock, causing the price to fall.

HighP/E is risky

A high P/E, therefore, means lots of risk.

So what is a reasonable P/E?

From 1935 through 2003, the P/E for the Standard & Poor’s 500 index, the most widely used market gauge, averaged 15.5, based on earnings reported in quarterly reports, according to Standard & Poor’s. That means paying $15.50 for every $1 in earnings.

But the figure has averaged 23.6 since 1988 and 29.5 since 1996.

Most experts seem to agree that the “normal” P/E is now higher than the long-term figure of 15.5, since conditions have changed over the years. Dividends, for example, are much smaller today than in the past, so investors focus more on share prices and tolerate higher P/Es.

At the same time, many agree that the 1996-2003 P/E of 29.5 was too risky, since the late ’90s bubble and subsequent crash were the result.

Still a little risky

So where does that leave us? Lots of pros think “normal” is around 20 – maybe. The S&P 500 recently ended the week with a P/E of 23.4 percent, indicating stocks are still somewhat risky.

Unless earnings grow, share prices would have to fall about 15 percent to get the P/E to a norm of 20.

There’s another problem: Which earnings figure should we use?

The long-term averages are based on “reported” earnings, but different accounting produces “operating” earnings, “pro-forma” earnings, “core” earnings and “forecasted” or “estimated” earnings.

It would take a book to explain them all.

The important thing is that any method that produces a higher earnings figure produces a lower P/E, making stocks look less risky.

Hence, Wall Streeters like to use the highest earnings figure they can rationalize.

Jeff Brown writes for the Philadelphia Inquirer.

recent letter to clients.

Of all the earnings figures available, he said, stock promoters like the forecasted earnings figure the best, since it gives the lowest P/E. Wall Street analysts have historically been overoptimistic in forecasting earnings for the next 12 and 24 months, he said.

If one used actual earnings reported over the previous 12 months, the S&P 500’s P/E at the end of December was 27.9, meaning stocks looked pretty risky, he wrote.

Using a “forecasted operating” earnings figure for 2004 put the P/E at only 17.7. That’s low if the norm is 20; stocks don’t look risky .

But, Asness argues, comparing forecasted earnings to a norm based on reported earnings is apples to oranges.

Instead, he says, forecasted earnings from the past should be used to figure the norm. The data, which goes back to 1976, shows that this produced an average P/E of 12.1. Today’s level of 17.7 means stocks are “a lot more expensive than the norm for the last 28 years,” he concludes.

If earnings don’t rise, stock prices would have to fall by more than 30 percent to get back to the norm.

Next, he takes on another of today’s rationalizations – that it’s OK for P/Es to be high when interest rates are low.

This view involves flipping P/E over and dividing earnings by price, producing a figure called earnings yield. If a company earned $1 per share and shares sold for $20, the yield would be 5 percent – $1 divided by $20.

That would be like getting 5 percent in a bank account, and today you can’t get that. This is the same as a P/E of 20 – $20 divided by $1.

But what if rates rose and you could get 6 percent on a safe bank deposit? Then you’d want more than that from a risky stock – 10 percent, perhaps. You’d be willing to pay no more than $10 for every $1 in earnings.

That would be a P/E of 10.

Conclusion: When interest rates are low, as they are today, investors will accept low earnings yields on stocks. In other words, they’d accept high P/Es. If so, today’s P/E of 23.4 looks all right.

But there’s a problem, says Asness: In the real world, low interest rates come in times of low inflation, which means companies cannot raise prices on the goods and services they produce. That hurts profits enough to offset the benefits of low interest rates.

Even when interest rates are low, high P/Es mean high risk, he says.

This doesn’t mean today’s P/E ratios spell imminent disaster. Even if companies cannot raise prices, they can increase earnings by cutting costs and selling more goods and services. So perhaps corporate earnings will rise enough this year to justify the current P/Es. That seems to be what millions of investors are betting on.

In fact, earnings for the S&P 500 rose a stunning 75 percent in 2003. But S&P analyst Howard Silverblatt says this wasn’t hard to accomplish because earnings in 2002 were terrible. Earnings growth should be much more moderate this year, he predicted.

Stock market investors can hope that not many people see things as clearly as Asness does. So long as investors THINK share prices should rise, they will.

That’s called a bubble – and we know what happens to them.

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(Jeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at brownjphillynews.com.)

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(c) 2004, The Philadelphia Inquirer.

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AP-NY-02-09-04 0631EST