Stocks may be high priced, but when
"The Big Correction" happens, shrinking corporate earnings
won't be the cause of any spectacular pileup for this
Corporate profits are lagging for the second consecutive
year, with recession in one-third of the world more than
offsetting the gain from the still vibrant U.S. economy.
But experts say the sad earnings story will not cause the
market to unwind. In fact, lousy earnings have not been the
chief cause of bad stock markets for a remarkable 64 years.
Bear markets have been triggered by rising interest rates
"Data suggest that for the last 64 years, or since 1934,
the market has largely shrugged off earnings drops as temporary
dips but has reacted violently to adverse changes in inflation
and interest rates," said Edward Keon, director of Quantitative
Research for Prudential Securities.
Interest rates are indeed powerful financial tools and their
ability to influence the stock market was shown last year when
the Federal Reserve faced with a free-falling stock market
launched a series of panicky interest-rate cuts to insure that
the United States was not dragged down by the economic crisis
The cuts did the trick, but they also lit a fire under the
market, sending stocks to record highs.
This week, Wall Street was on pins and needles, wondering if
the interest-rate setting Federal Open Market Committee would
change its monetary policy, and start to raise the rates. The
central bankers, however, voted to keep rates unchanged even
as the U.S. economy expanded at the fastest pace in 2-1/2 years,
which heightened the risk of inflation.
The impact of interest rates was also felt in 1994, when the
Fed sent stocks reeling after it doubled them from 3 percent to
5.75 percent in a preemptive strike against what it saw as the
threat of inflation.
The big worry now is that stocks have gone too far.
Analysts say corporate earnings are not increasing as
quickly as stock market valuations and investors will have a
tough time justifying their expectations of companies' earnings
potential, as measured by the forward-looking price/earnings
ratio. The P/E, as it is called, is at a record 25 times
earnings for the stocks in the Standard & Poor's 500 index.
But some are challenging the way Wall Street gauges P/Es.
Allen Sinai, chief global economist for Primark Decision
Economics, said stocks are priced just right.
The problem is that the people who preach that stocks have
vaulted beyond reason and should come down to more realistic
levels are viewing the market through a rear-view mirror, he
"The price/earnings ratios of the '70s and '80s, which
averaged out then to about 17 times earnings, have to be tossed
out because they're not the measures of comparisons for stocks
of the '90s," Sinai said.
"In this era of great technological change, great corporate
balance sheets and low interest rates, we have to rethink what
the P/Es should be," he said.
In this new economic world, the P/Es should range between 22
and 26 times earnings, which would put the fair-value of the Dow
index between 8,300 and 9,700, according to Sinai's
calculations. The Dow was hovering at about 9,280 Friday.
Added Keon, "It may be perfectly sensible right now for
investors to pay 25 times earnings, but this can't keep
expanding forever and eventually people will have to rely on
actual earnings growth."
He expects the P/E will continue to increase, leveling off
at a high of 29 by the year 2001. After that, it will curve down
until it reaches less than half of today's numbers.
The P/E is the price of a stock divided by its earnings per
share. For instance, a stock selling at $20 with projected
earnings of $2 a share next year will have a forward P/E of 10.
What are the odds that 1999 could be a rocky year for
"The risk of a huge market drop this year is no greater
than it has been historically," said Keon said. He put the odds
at one in five.
But this is a special year and investors, he said, should
stay alert for signs that the economy does not deteriorate and
the Year 2000 computer bug does not turn out to be a monster
The tremendous stock market gains may be coming to an end.
"We'll probably have two more good years but starting with
2001 we will see market returns of 10 percent rather than 20
percent, as stock valuations reach their natural limits."
For the week, the Dow Jones industrial average was off 54.59
points at 9,304.24. The Standard & Poor's index lost 40.24 at
1,239.40 and the NASDAQ composite index fell 132.27 at 2,373.62.