Cheap stocks - if the economy isn't broken
Equities are relatively undervalued, unless the government's stimulus package creates inflation.
(breakingviews.com) -- With the Dow Jones Industrial Average below 7,000, the U.S. stock market is well below its early-1995 level, adjusted for changes in nominal GDP.
That suggests it's cheap - if growth prospects are as good as they were back then. The risk, however, is that too much fiscal and budgetary stimulus will bring on growth-stultifying inflation.
On December 5, 1996, the Standard and Poor's 500 Index (SPX) closed at 744.38. That evening, Fed Chairman Alan Greenspan decried the market's "irrational exuberance." At its March 2, 2009 close of 700.82, the market is clearly exuberant no more.
It is not, however, exceptionally low. Greenspan announced a new easier monetary policy to Congress on February 23, 1995, the day the Dow Jones industrial average (INDU), which had been generally rising since 1990, first reached 4,000.
Adjusting for the 95% increase in nominal GDP since that time would give an equivalent Dow level today of around 7,800. That suggests that current levels are only somewhat below their long term trend, and that the 1996-2007 period represented a lengthy bubble.
Standard and Poor's currently projects 2009 earnings on the S&P of $48.10. Over the 20-year period to 2008 the index traded at an average of 19.4 times earnings. That would give a current value of 933.14.
That 20-year period however includes the 12-year bubble; taking a longer-term average of around 15 times earnings gives a valuation of 721.5, again, just slightly above the current level.
So, based on 1995 stock prices and long-term earnings considerations the market is just below a middling valuation. However that assumes U.S. growth and earnings prospects are as good today as they were in 1995, or over the long-term average.
That's where doubts creep in. If the exceptional monetary stimulus since September produces inflation, which needs to be squeezed out, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 "crowd out" private investment, then growth and earnings prospects for the next few years would be below average.