are sky-high stock prices
By Shawn Tully, Fortune editor
(Fortune) -- With the S&P down over 10% from its October record high, TV pundits and Wall Street strategists are blaming the most obvious culprits for the sudden reversal of fortune, chiefly the subprime crisis and the looming threat of a recession. But it's neither the credit crunch, nor a slowing economy -- nor a third hobgoblin, the weak dollar -- that pushed the markets into correction territory Monday.
The real reason is so basic, and so antithetical to Wall Street's habitual happy talk about stocks, that it barely rates a mention in the market chatter. Put simply, stocks are extremely expensive relative to the daunting risk in owning them. At current prices, earnings can't possibly grow fast enough to give investors the fat returns they covet.
There's just one way for equities to get their lustre back -- their prices have to fall substantially so that investors can harvest attractive returns from the modest profit growth that's in the cards. Like the biblical sheik who hastens to Samarra to escape death, only to find death waiting for him there, stocks have an inescapable appointment with a withering fate.Naturally, stocks could bubble back to their old heights in the next few weeks or months. If the recent past proves anything, it's that the course of equity prices is totally unpredictable from day to day or quarter to quarter. As the economist Milton Friedman once told me, after returning my call collect, "Stock prices are rational in the long-term, but in the short-term, they're far from rational. They're full of noise."
But don't let the Wall Street crowd fool you into thinking that the current decline is mostly noise, an irrational blip in a bull market caused by a spate of bad news. What we're probably witnessing is a massive, irreversible revaluation of stocks based on fundamentals. The repricing machine is now in motion. The smart money says it won't stop, despite feints and lurches, until stocks are a bargain again, a prospect investors haven't seen in years. Why are stocks at a probable turning point? The reason is that investors' perception of the potential perils of holding equities has changed substantially in the last few months. In any major shift, it's impossible to predict what the catalyst will be. In this case, it was the subprime mess. Again, subprime was the catalyst, not the cause. It wasn't just a crisis that would pass, as the pundits argued, but a flashing red warning that triggered a durable shift in investor psychology.....Now, the fear of risk is spreading to equities with a vengeance. The problem with equities is that the repricing following the bubble of the late 1990s never fully played out. Stocks roared back from their 2001 lows, reaching record levels this fall. The rub is that they were, and still are, extremely expensive.
The best way to measure whether stocks are giving you enough juice for the risk you're taking is examining the equity risk premium. This is the ultimate number in corporate finance, what Dartmouth economist Kenneth French calls "the holy grail" of stock investing. ...Earnings are now near a cyclical peak, having jumped more than 60% since 2001. They're now more than 12% of GDP versus an historic average of around 9%....So where does that put the equity risk premium? With a PE of 22, the earnings yield is just 4.5%. So the return investors can expect from equities is 4.5% plus expected inflation of 2.5%, or around 7%. To get the equity risk premium, subtract that expected return from the 10-year treasury rate of 4%. That's the extra lift investors get for choosing the perils of holding stocks over the comfort of owning government bonds. The most dangerous sector is technology. Just look at the lofty PE's. The big names like Microsoft and Intel boast multiples of between 20 and 25, yet they're now giant, mature enterprises that, because of their sheer size, can't grow profits nearly fast enough to justify their high prices.
For the Googles and Yahoos, the outlook is far scarier. Google's PE now stands at 52. Say you're expecting a 10% a year return from Google . Its market cap would have to double to more than $400 billion by 2014. Even if Google kept a stellar PE of 30, it would need to earn $13 billion by then. Today, it earns about $4 billion. So its profits would need to more than quadruple in seven years. It won't happen.
For the bulls, the coup de grace is the math -- earnings growth cannot bail out the market. The reason is that what really counts, earnings per share, don't even grow as fast as GDP. That's because companies regularly issue more shares and dilute their current shareholders -- the explosion in stock options is only the most obvious example. Because of the big dilution, earnings per share grow far more slowly than GDP; the best estimate is around 2%, adjusted for inflation....Forget the chatter, ignore the headlines, and follow the math. Prices will get a lot more attractive. The process is underway. All investors have to do is wait.
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