U.S. Stocks at 25.8 Times Earnings Means Rally Can't Continue

By Michael Tsang and Jeff Kearns

Sept. 2 (Bloomberg) -- The best already may be over for the U.S. stock market this year.

The Standard & Poor's 500 Index, which had the worst first half since 2002, added 0.2 percent this quarter, the only gain among the world's 10 biggest markets in dollar terms. Shares in the benchmark index for American equity climbed to an average 25.8 times reported profits, the highest valuation in five years. The last time that happened, the S&P 500 fell 38 percent.

Money managers at Federated Investors Inc., Russell Investments and Morgan Asset Management, which oversee a combined $600 billion, said the gains won't last because corporate profits will fail to meet analysts' estimates. Wall Street forecasters, who were too optimistic about earnings for the past four quarters, predict income at America's biggest companies will grow by a record 62 percent in the final three months of 2008, according to data compiled by S&P.

``The market is pricing in the expectation of a good quarter, but we just don't see it,'' said Philip Orlando, who helps manage $350 billion as chief equity market strategist at Federated in New York. ``The fundamentals are going to be poor, earnings are going to be bad, and there are going to be more huge writedowns. We think stocks probably need to work 5 to 10 percent lower over the next month or two.''

Analyst estimates were at least 26 percentage points too high since the fourth quarter of 2007 as they failed to anticipate more than $500 billion of subprime-related bank losses and a slowing economy, according to data compiled by S&P and Bloomberg.

Rising Multiples

The S&P 500 slipped 0.7 percent last week, its second straight retreat, as growth in consumer spending slowed and incomes fell. The index fell 13 percent this year, led by a 27 percent decline in a measure of financial stocks.

A combination of rising prices and falling earnings caused S&P 500 valuations to surge more than 20 percent this quarter, the biggest increase of any major market, making them the most expensive since November 2003.

The index's price-earnings ratio rose above 25 three times in the last five decades, data compiled by Bloomberg show. The last was in 2001, during the bear market that followed the bursting of the dot-com bubble. The increase in valuations preceded a plunge that helped erase about half the market value of U.S. companies.

The ratio is being propped up now by analyst forecasts that call for the end of four quarters of slumping profits, the longest streak in seven years.

Discounted Risk

S&P 500 companies will report aggregate earnings of $21.69 a share in the current quarter, a gain of 3.9 percent from a year ago, and $24.62 a share in the final three months of 2008, 62 percent higher than last year's fourth quarter, based on projections compiled by S&P. The earnings reflect estimates for the index, adjusted for each company's weighting.

RidgeWorth Investments' Alan Gayle says prices already discount the risk of a recession, making U.S. equities attractive as profits slow internationally.

Nations sharing the euro may expand 1.5 percent this year, the slowest since 2003, according to the median forecast in a Bloomberg survey of economists. Japan, the world's second-largest economy, will grow 1.05 percent, a six-year low. China, the fastest-growing major economy, may have its smallest expansion in five years.

``The U.S. economy, while not strong, has a greater visibility of the bottom,'' said Gayle, the Richmond, Virginia- based chief investment strategist at RidgeWorth, which oversees $70 billion and went ``overweight'' U.S. stocks a month ago. Outside the U.S., ``the risk factor in the earnings estimates is a little higher than you might see on Wall Street.''

Gap, AK, Lexmark

More than 360 companies in the S&P 500 trade below the average valuation, providing opportunities to investors who pick individual stocks. Gap Inc., the biggest U.S. clothing retailer, AK Steel Holding Corp., the fourth-largest U.S. steelmaker by market value, and Lexmark International Inc., the second-biggest U.S. printer maker, are priced below 15 times earnings, even after reporting income gains of more than 30 percent in the second quarter.

Investment banks are advising clients to buy stocks in anticipation of the earnings rebound. The average forecast of 10 strategists tracked by Bloomberg is for the S&P 500 to rise 14 percent from last week's close to 1,456.50. Thomas Lee, chief U.S. equity strategist at New York-based JPMorgan Chase & Co., said last month that U.S. equities will rise ``much higher'' as profits improve.

Should analysts overstate profits in the second half by the degree they did last quarter, earnings for S&P 500 companies will fall to about $72.17 a share. That would be below the level of 2005, when the S&P 500 was on average 5.9 percent lower than today.

`Fundamental Problems'

The U.S. economy won't support the earnings analysts predict, said Walter ``Bucky'' Hellwig, who oversees $30 billion at Morgan Asset Management in Birmingham, Alabama.

Economists forecast U.S. economic growth will slip to 1.5 percent this year from 2 percent in 2007 as demand for exports wanes, according to a Bloomberg survey.

Exports accounted for all but 0.2 percentage point of the U.S. expansion last quarter, when the economy grew 3.3 percent. The jobless rate rose to 5.7 percent in July, the highest since 2004, and consumer spending increased at the slowest pace in five months, government reports showed.

``Despite this upturn in the stock market, the fundamental problems are still out there,'' Hellwig said. ``Those issues haven't gone away. That would necessitate a ratcheting down of earnings estimates, and that would imply lower stock prices.''

Steinhardt's Doubts

The most bullish profit forecasts are for U.S. financial companies. In the fourth quarter, brokerages and insurers will boost earnings almost fivefold from a year ago, analysts say.

``I don't believe we're through this credit crunch,'' said Stephen Wood, New York-based senior portfolio strategist at Russell Investments, which oversees $213 billion. ``Credit portfolios are beginning to deteriorate. Financials will continue to exert downward pressure on earnings for the balance of 2009.''

Bank of America Corp., which earned 7 cents a share in the fourth quarter of 2007 after doubling reserves for potential loan losses to $3.3 billion in the period, will make 77 cents next quarter, according to analysts surveyed by Bloomberg. The Charlotte, North Carolina-based lender, the second biggest in the U.S., gained 30 percent this quarter.

Citigroup Inc., the largest U.S. bank, advanced 13 percent. Analysts estimate the New York-based company, which reported $55.1 billion in losses and writedowns, the most of any financial institution, will earn 43 cents a share in the fourth quarter. That compares with a loss of $1.99 a year ago, Citigroup's biggest.

Michael Steinhardt, who returned an average 24 percent a year for almost three decades when he ran his New York-based hedge fund Steinhardt Management Co., said forecasts for an earnings rebound are a false hope.

``My intuition is that they are too early,'' he said. ``In an ordinary cycle, this should be the time to start thinking about buying. This isn't an ordinary cycle.''

To contact the reporters on this story: Michael Tsang in New York at mtsang1@bloomberg.net; Jeff Kearns in New York at jkearns3@bloomberg.net.