Doomsday? Three Market Myths

08/26/2014 9:00 am EST


Richard Moroney

Editor, Dow Theory Forecasts

The doomsday case for the stock market is overstated, suggests Richard Moroney; here, the editor of Dow Theory Forecasts looks at three market myths.

The major averages have stabilized after a significant correction, but the rebound has not covered enough ground for the lows reached this month to qualify as bear-market points. Our buy lists have 91% to 94% in stocks.

While nobody knows whether the bears or bulls will be proved right, three arguments of the most strident bears seem overstated:

Myth No. 1: Stocks have entered bubble territory, with ridiculously high valuations.

Reality check:  The trailing price/earnings ratio of the S&P 500 Index (SPX) is about 18—in line with the median monthly P/E since 1980.

The index’s earnings yield, or earnings/price ratio of 5.4% is about 2.9% higher than the yield on 10-year Treasury bonds. Since 1980, 10-year T-bond yields have typically exceeded the earnings yield, with a median spread of 1.3%.

The index’s P/E is being weighed down by modest multiples for the largest US companies. But the median P/E of all stocks in the S&P 500 is about 18.5, only slightly higher than the norm since 1994. For stocks in the broader S&P 1500 Index, the median P/E of 20 is 11% higher than the 20-year norm.

Myth No. 2:  Corporate earnings growth has stalled.

Reality check: The median S&P 500 company delivered 9.0% year-to-year growth in corporate profits in its most recent quarter, slightly below the norm of 9.6% since 1994. For the S&P 1500, the median growth rate of 7.5% is below the norm of 9.1% since 1994.

Myth No. 3: Earnings are only growing because of cost cuts and streamlining moves. Sales are not growing.

Reality check: The median S&P 500 company reported 6.8% year-to-year sales growth in its most recent quarter, above the norm of 6.1% since 1994. The median for S&P 1500 companies, 6.0%, nearly matches the 20-year norm of 6.1%.

Our advice: Don’t be discouraged by bears peddling gloom and doom. The broad stock market is expensive but not outrageously so. Earnings and sales are growing.

The big question, in our view, is whether earnings and sales will continue growing at a healthy rate—or whether growth will stagnate because of slowdowns overseas, geopolitical conflicts, rising short-term interest rates, or cyclical pressures on profit margins.

For insight on this question, we intend to listen to the averages. A rebound above the July highs in the averages would be encouraging.

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