Are Stock Prices Fair?

One of the great ad slogans of many years ago was, "When was the last time you lost an argument quoting The New York Times?" But David Leonhardt had a column in Wednesday's edition of the Times that I am going to dare to take exception to.

"Are stocks the bargains you think?" was the header. In the text, he mentions that the ratio of stock prices to earnings is slightly below the long-term average, but that there have been times of much lower valuations. That is absolutely true, but with a caveat. The trailing price-to-earnings ratio has averaged about 16 times for a long time, but Leonhardt points out that in 1982 it was 7, and roughly the same in the 1970s debacle. But -- and it's a big "but" -- the yield on the 10-year Treasury bond was much higher in both instances. In 1982, the 10-year yield reached 14.6% and the 1974 stock market bottom saw a 8.5% yield. The 10-year is about 3.6% today. You can't look at the one without the other.

The current value of today's market when compared with the alternate investment option of the fixed-income market makes me believe stock prices are fair. They're fair assuming that earnings bottom in 2009. If we have entered a period of deep recession and a very long laborious recovery, then the sideline is the place to be.

We have been using a very low estimate for 2009 per-share earnings for the S&P 500. Our back-of-the-envelope calculation led us to a $60-to-$65 number. The consensus among analysts a few weeks ago before the extent of the current crisis became obvious was well over $90. We guessed that the consensus would have to come down and stocks at best struggle when estimates are falling. Citigroup's economist reportedly lowered his estimate for 2009 to $64 on Wednesday. We need to see more of that in the weeks ahead before we can possibly hope to get positive surprises in the months ahead.

The big question is how deep and long will the recession be. My guess is that it will not be as deep as could be imagined because of the flood of liquidity unleashed upon the markets. The length could be stubbornly long as consumers retool their balance sheets and raise their savings rates.

I am hopeful that earnings will bottom in 2009. If that proves right, the current market value of 930 on the S&P divided by a $64 estimate for a P/E ratio of 14.5, against a 3.8% 10-year bond, is investable.