he bubble burst a long time ago, and now stock market valuations are far more reasonable.
So goes the Wall Street line. But a look at the numbers raises questions about that happy conclusion. The price-earnings ratio of the Standard & Poor's 500-stock index reached its highest level ever yesterday, at 35.99. That figure, based on reported profits over the last 12 months, exceeded the record of 35.82 set on April 12, 1999.
How can that be? Share prices are down a lot from the peak in 2000, but so are profits. Profits surged in 1999 and early 2000, keeping the P/E ratio from reaching new highs even as the market did. But since then the profit figures have been plunging precipitously.
It should also be noted that the historical earnings figures now being used include only a handful of companies that have reported third-quarter results. Chances are that many third- and fourth-quarter reports will be dreadful, leading to even higher price-earnings ratios.
The second quarter was bad enough. According to calculations by Bloomberg Financial Markets, S.& P. profits for the period were lower than they were in the second quarter of 1990, just before the last recession began.
Wall Street thinks such numbers are unfair. They are based on historical profits, while investors should be looking at future earnings. Though they exclude extraordinary items, they include write-offs that companies think are best ignored. Wall Street focuses instead on estimates for 2002 pro-forma operating earnings, which exclude whatever the company wants excluded. The S.& P. is trading at 19 times that forecast, which Wall Street says is cheap given the current low level of interest rates.
Wall Street's argument is reasonable in part. A company's future operations should matter most to investors, and many write-offs now being taken represent losses that should have been taken in prior years, not this one. But, says Thomas Coleman of Aequilibrium Investments, a money management firm based in London, focusing on pro-forma operating earnings in the aggregate ignores a lot of losses, and those losses are real. Moreover, the difference between reported profits and operating profits has grown over a sustained period, as companies have become more adept at making operating numbers look better. That distorts historical comparisons based on operating profits.
In a study to be released next week, economists at the Jerome Levy Economics Institute at Bard College estimate that overall earnings of the S.& P. 500 are overstated 20 percent. Like Mr. Coleman, they raise the same issue of operating vs. total profits, but add that the 1990's boom in stock options also led to a rising exaggeration of earnings because few companies treated the value of the options as an operating expense.
Does this matter? In the short term, probably not. Valuation is not very useful in market timing. The important issue in the coming months will be the economic outlook, and share prices will probably do well if investors continue to expect an early end to the recession. That hope has driven the S.& P. back to where it was before Sept. 11.
But it is worth noting that the extraordinary high multiples of the late 1990's coincided with expectations of rapid growth for the economy and for corporate profits. If those expectations come down, lower valuations may come to seem appropriate even after the recession ends. Instead of growing faster than profits, as happened in the last decade, stock prices could fail to keep up with earnings.
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