Photo: Andrew Burton
NEW YORK (AP) — The stock market is missing you.For more than three years, ordinary investors disgusted with wild swings have pulled money out of stocks. They’ve missed a breathtaking bull market: The Dow Jones industrial average has almost doubled from its low point during the Great Recession on March 9, 2009.
In the meantime, corporate America has racked up double-digit profit gains. If investors valued stocks at normal historical levels based on profits, we would be celebrating Dow 15,000, not Dow 13,000.
But the profit explosion is over, and the Wall Street pros who trade stocks mostly for big institutions and the rich are getting antsy. They’ve been doing the buying. And if Main Street doesn’t join them, the historic rally could slow or even end.
Everyday investors “are more aware of the risk of the market,” says Howard Silverblatt, senior index analyst at Standard & Poor’s. “They’re nervous. They’re scared.”
The Dow closed above 13,000 last week for the first time since May 2008, four months before the financial crisis. In a sense, the milestone was disappointing: Profits are at an all-time high, yet the Dow is well below its record of 14,164, set in October 2007.
Even though profits are growing, individual investors aren’t buying. That shows up in something called the multiple — the ratio of what investors are willing to pay for a company’s stock, compared with its annual profits.
If a stock trades for $100 and the company has made $5 in profit per share, its multiple is a fairly high 20. A higher multiple means more confidence that profits will grow. Maybe investors believe the company will turn a bigger profit next year of $7 or $8.
These days the multiples don’t show much confidence.
Investors are paying a multiple of 13.5 times the past year’s earnings for stocks. The typical multiple over the past 75 years is 16. If that were the multiple today, the Dow would be sitting above 15,000.
“We’ve built profits in the past three years,” says Jim Paulsen, chief investment strategist at Wells Capital Management. “Now we need to value them differently.”
The chatter on Wall Street about multiples comes as stock analysts worry that the double-digit profit growth is largely over.
For the first three months this year, profits of companies in the widely followed S&P 500 index are expected to grow just 0.4 per cent over the same period last year, according to FactSet, a provider of financial data.
For all of 2012, they are expected to climb 9 per cent. That assumes they will pick up toward the end of the year. That would be a healthy gain but will leave the index short of its record high unless investors get more excited.
If the earnings predictions for this year come true and the multiple stays in its rut, the S&P 500 will reach 1,421, well shy of its own record of 1,565. And the earnings projections may prove optimistic. Analysts have been slashing them lately.
The modest profit picture doesn’t necessary doom the rally. There have been periods when earnings barely budged and stocks soared. In the five years through 1986, stocks in the S&P 500 nearly doubled while earnings slipped 2 per cent.
The explanation is the magic of rising multiples. The average zoomed from nine times earnings to nearly 17 times. Could we be entering a similar period of growing confidence?
Paulsen thinks so. He says that investors have shaken off fears of another recession and that debt-ridden Europe appears on the mend. He expects investors will value stocks at 15 times earnings by the end of the year, pushing the Dow and S&P closer to their records.
Jeffrey Kleintop, chief market strategist at LPL Financial, one of the nation’s largest brokerages, thinks the market won’t reach a record anytime soon. First, “people need to embrace stocks,” he says. “Maybe next year.”
One measure to watch is the flow of money in or out of U.S. stock mutual funds. From June through January, investors pulled $137 billion more from these funds than they put in, according to Strategic Insight, an industry consulting group.
Their apparent skittishness has led to less trading. About 3.9 billion shares of stock have traded on an average day this year at the New York Stock Exchange, down a third from three years ago.
The refusal by ordinary investors to buy stocks is even more surprising when you consider how little they’re making from the alternatives. Their favourite assets of refuge— CDs, money market funds and U.S. government debt — don’t even throw off enough interest income to compensate for inflation.
If stocks do return to a more normal 16 times profits, they’re not likely to hover there for long. They tend to trade at widely varying multiples. Since World War II, stocks have traded as low as six times earnings and as high as 47.
What’s more, stocks can stay at seemingly cheap or expensive multiples for long stretches. For the three years during the boom in dot-com stocks in the late 1990s, stocks in the S&P 500 traded at an average 37 times their previous year’s profits. In the 10 years through 1951, they rarely broke 10.
At today’s earnings, a 37 multiple would put the Dow at more than 36,000, according to FactSet. A multiple of 10 would sink the average to about 9,800.
All these hypotheticals can mislead, of course. To judge whether stocks are cheap or expensive, experts say you need to look at many figures, not just last year’s earnings.
Some also like to look at an average of earnings over the past 10 years to iron out the peaks and valleys in business cycles. By this measure, stocks are trading at 22 times earnings compared with a historical average of 16. In other words, stocks may be too expensive.
One school of thought holds that multiples of all kinds should be lower now because the U.S. has entered a period of slow economic growth and lower profits as governments and households pay off their enormous debts. Bill Gross, co-founder of the giant investment company Pimco, calls this a “new normal.”
Even if you don’t believe Gross is correct, perception could become reality. If enough people refuse to buy stocks because they don’t think prices will rise much, they won’t rise much.
Harvey Rowen, the chief investment officer for Starmont Asset Management, says he’s seen this self-fulfilling attitude among his clients. He says the clients who are calling want him to move more of their holdings into cash, or maybe gold.
“Nobody calls up to say, “Buy equities,” he says.