‘Black Monday’ Fears Hit Wall Street : The ‘Right’ Price for Stock May Depend on a Buyer’s Outlook on the Economy
No matter what happens to share prices today in the emotion of the moment, level-headed investors will soon come back to one basic question: What are stocks really worth?
The answer, of course, depends on your outlook for the economy and thus for corporate earnings in 1992. Based on what many analysts consider to be realistic expectations for profits next year--given a slow-growth economy at best--the surprise may be that stock prices haven’t been outrageously high.
If that was true before last Friday’s steep market plunge, then any subsequent decline this week could make many stocks enormously attractive for long-term investors.
Is that too Pollyannaish? What about all of the “speculation” that had supposedly dominated Wall Street until last Friday? Isn’t that a signal of a market top?
William Berger, a veteran Denver money manager who has lived through many market bull and bear cycles, argues that most of the market’s speculative fever this year has been concentrated in just one area: biotech stocks.
Those issues were doubling and tripling in a matter of weeks, and everyone on Wall Street knew the game would be up soon. But apart from biotech, “you just don’t see the same froth elsewhere” in the market, Berger maintains.
True, small stocks in general have been red-hot this year. But the 42% year-to-date gain in the NASDAQ composite index of 4,000 smaller stocks has to be put in perspective: The index had plunged 18% last year. At 531.29 on Friday, the NASDAQ index is just 17% above its level at the end of 1989.
On their own, though, stock prices don’t mean much. To judge if a stock is expensive or cheap, you have to look at the price relative to the company’s earnings per share, and the expected growth in earnings over the next few years.
With Friday’s decline, the average stock in the Standard & Poor’s 500-stock index now is priced at 15 times estimated 1992 earnings per share. Steven Einhorn, investment strategist for brokerage Goldman, Sachs & Co. in New York, says that 15 “P-E” (price-to-earnings ratio) is actually below the historical average P-E of 15.5 for the S&P; index in times of moderate inflation.
Translation: Stocks are slightly undervalued by historical standards. Or put another way for those investors worried about alleged speculation, stocks are “no where near the overvalued levels of previous (market) peaks,” Einhorn says.
But his forecast, like most analysts’, assumes that corporate profits will grow by a decent amount next year. On average, Wall Street expects profits for blue chip companies to grow 18% next year from depressed 1991 levels. And for profits to grow, the economy will have to grow.
In Friday’s market plunge, many analysts said the driving force was the fear that the weakening economy is falling back into recession, which could mean a decline in corporate profits next year rather than growth.
If that indeed is what’s happening to the economy, then the market as a whole likely is headed much lower before this is over.
But analysts such as Einhorn don’t buy the new-recession scenario. “We reject this economic ‘black hole’ scenario in which the economy wallows in a long-lasting recession,” he says. “We do not disagree that the 1992 recovery will be less energetic than previous cycles. But modest growth is far different from no growth.”
For the sake of argument, let’s say the actual outcome is somewhere in between the bull and bear case: Maybe the economy does sink further early in 1992, then stages a feeble recovery that continues to look suspect even into next summer. Where does that leave stock prices?
Certainly, any firm that fails to produce the profit growth Wall Street expects will see its stock pushed lower. But the past year has taught many investors to forget what’s happening to the economy as a whole, and focus on how individual companies are faring.
Despite a weak retail-sales environment all year, for example, the Gap clothing store chain has managed to post strong sales gains. For the few consumers who do go shopping, Gap seems to be one place they continually visit.
Wall Street believes that Gap’s earnings will rise 21% in 1992. And based on the 1992 earnings estimate of $1.75 a share for the firm, the stock now trades at 28 times earnings. That is well above the average stock P-E of 15, of course--but that’s because Gap has consistently shown that it can perform well in a tough economy.
The message here is that no matter what happens to the broad economy, many companies will continue to show rising profits in 1992. So even if stocks take a severe drubbing in the near-term, those firms that deliver on earnings next year will almost certainly see their stocks rebound handsomely, and probably sooner rather than later.
“Value” in stock prices is always in the eyes of the beholder. If more investors decide in a momentary panic that there’s less value than they had believed, prices will fall. But ultimately, healthy earnings growth is always rewarded with higher stock prices. That’s something to remember if Wall Street today suffers another Black Monday.
Are Growth Stocks Overvalued?
Stocks are way up this year, but are they up too much relative to the earnings companies are likely to produce in 1992? Here’s a look at analysts’ consensus earnings per share (EPS) estimates for some key growth companies, and the stocks’ price-to-earnings ratios (P-E) based on 1992 estimates.
Fri. YTD EPS estimates Est. EPS P-E on Stock close gain 1991 1992 growth Amgen $52 +151% $1.25 $1.81 +45% Home Depot 57 3/4 +124% 1.15 1.49 +30% Wal-Mart 47 3/8 +57% 1.41 1.73 +23% Gap Inc. 48 1/4 +192% 1.45 1.75 +21% Jacobs Engineering 24 +88% 0.86 1.03 +20% Circus Circus 34 1/4 +25% 1.93 2.30 +19% Gillette 43 3/4 +39% 1.97 2.34 +19% S&P; 500 382.62 +16% 21.83 25.71 +18% Merck 137 +52% 5.44 6.42 +18% Coca-Cola 64 3/4 +39% 2.42 2.86 +18% Sunrise Medical 34 1/2 +57% 1.70 1.95 +15% FNMA 56 1/4 +58% 5.02 5.73 +14% Anheuser-Busch 53 1/4 +24% 3.27 3.69 +13% Franklin Resources 48 +59% 2.51 2.76 +10%
Stock ’92 est. Amgen 29 Home Depot 39 Wal-Mart 27 Gap Inc. 28 Jacobs Engineering 23 Circus Circus 15 Gillette 19 S&P; 500 15 Merck 21 Coca-Cola 23 Sunrise Medical 18 FNMA 10 Anheuser-Busch 14 Franklin Resources 17
All stocks trade on NYSE except Amgen and Sunrise Medical (NASDAQ).
Source: Zacks Investment Research
