By Roger Lowenstein
Don't kid yourself about new paradigms and interleague baseball: The stock market is high. Not every stock. There are plenty out there that can be bought today and provide a return, though probably not as high a return as in the recent past. But if you buy the market as a whole, and anyone who owns a Standard & Poor's 500 index fund does, it's an expensive time to get in.
At today's prices, you are getting less in terms of underlying earnings for each dollar you invest, and less in future earnings discounted at appropriate interest rates. Admittedly, the market was a lot more expensive before the 1987 crash. But it's less attractive now than it has been in years. And it's significantly worse than six months ago, when Alan Greenspan's S&P angst was making headlines.
As per usual, this column values stocks by their expected future free cash flow, discounted back to the present. Earnings are a proxy -- imperfect but the best we have -- for free cash flow, which is the spare change that the underlying businesses throw off to their owners after paying for salaries, interest, capital maintenance, taxes and Danish for their chief executives, in addition to eight-figure bonuses.
These underlying earnings, incidentally, are the only source of profit for investors, viewed collectively. You, individually, may get rich on a stock irrespective of what the company earns, by selling to somebody else at a higher price. (Of course, that "somebody" could turn out to be you.) But the seller's reward in such a zero-sum trade will come at the buyer's expense. The only net rewards to investors are the profits (whether distributed or retained) of the businesses they own.
IBM's earnings enrich its owners. But when one stockholder sells to another, nothing changes for the owners as a group, regardless of the price of the trade. That's why it pays to watch the outlook for the company's profits, as distinct from the people trading its stock.
The value of future profits necessarily depends on the discount rate. At 10%, $11 of profits next year is worth $10 now, and so on. As in the past, we'll use the risk-free (government) rate on long-term money. You can also think of the Treasury-bond rate as a hurdle: Why invest in a stock if the government will pay you more?
Over time, the earnings yield of the S&P (the 12-month anticipated earnings divided by the price) has invariably tracked the long-bond rate. At the beginning of the '90s, for instance, the bond yielded 7.98%; the S&P yielded 8.56% ($8.56 of expected earnings for each $100 of investment). Since the yield on stocks was a little higher, investors were paying a little more for the certainty of bonds, a little less for the growth potential of stocks. But, as the chart shows, they rarely pay a lot more for either, and never do so for long.
When the Dow broke 5000, in late 1995, the market seemed (to people impressed by three consecutive zeroes) high, but wasn't. Bonds yielded 6.3%; stocks yielded 7.2%, nearly a full percentage point more. But since then, interest rates have risen, and earnings growth has slowed considerably. However, the stock market has soared. By last December, the two yields were in a dead heat, each at roughly 6.4%.
Six months later, the discount on stocks has become a yawning premium. The earnings yield on the S&P 500 (thank you, I/B/E/S International) is a scant 5.48%, more than a percentage point less than the bond yield of 6.68%. Put $100 in the S&P and your implicit one-year return is $5.48, minus some discount for uncertainty. The year after, if earnings sustain 10% growth -- by no means assured -- that return would be $6. By the year 2000, the return on the S&P might even be as much as the government will pay you now. That's a bad bargain.
It's no secret why investors are paying up. After a period of seemingly easy profits, standards slip. James Paulsen, chief investment officer of Norwest Investment Management, recently told me that he owns stocks that are "difficult" -- meaning difficult to justify -- "from a valuation perspective." It would be interesting to consider what perspectives other than valuation he and the many like him are employing.
What they mean, I think, is that valuation has become relative: My $100 cat is cheap compared with your $90 dog. Kellogg, a modestly growing company in a mediocre industry, is priced at 24 times earnings over the next 12 months. (That's an earnings yield of 4.2%; you can eat a lot more cereal clipping bonds.) The word on the Street is that Kellogg is a buy because it's cheaper than Coca-Cola. This is a very interesting notion. Unless Coca-Cola is feeling uncharacteristically altruistic, it will be difficult for Kellogg's stockholders to collect a dividend based on the relative earnings at Coke. No matter, the niftier (more expensive) stocks are exerting an upward drag on the rest. Price (what the most recent investor pays to get in) is thus confused with value.