Dollars and Sense: Are we headed for a stock slide?

Earnings season. For the past couple of weeks, we’ve been talking about earnings season. It’s now winding down. How did we do? If your standard is short-term gain, then we did pretty well. A majority of stocks beat earnings expectations every quarter. In fact, about 63 percent of stocks beat expectations, and that’s about the percentage we had this quarter. So that was good. Nothing special, but no surprises. The result: For the month of October, the Dow Jones gained about 3 percent, the S&P 500 advanced nearly 5 percent and the Nasdaq added about 4 percent.

Clouds on the horizon. I should add, though, a big “but…” to all that good news. More companies than normal missed revenue projections, and they’ve done that in four of the past six quarters. So even though earnings were OK this quarter, they really needed to be more than OK to support the current stock prices. One of the better ways to price stocks is as a multiple of earnings. That’s called the price-to-earnings ratio, or the PE ratio. Historically, the PE ratio has been about 15. Currently, the PE ratio is above 19. The last time it was above 19 was just before the crash of 2008. The time before that was just before the tech bust of 2001.

Ominous signs? I don’t want to be Dr. Doom. After all, before the housing bubble crash, the PE briefly spiked above 60, and we’re a very long way from that number, but there’s an old saying that most stable systems eventually revert to the mean. That means that the PE ratio will eventually find its way back down to about 15 or 16. There are only two ways to do that. First, earnings have to get much better, or stock prices have to fall. The latest round of reports suggest that earnings are growing, but not nearly fast enough to support current stock prices.

Not all bad. That said, the news wasn’t all bad this week. Among the positive reports was a gauge of business activity in the Midwest that blew past expectations in October, posting the best number in 30 years. Also on Thursday came news that weekly initial jobless claims dipped. But good economic news caused buyers to wonder how long the Fed program will last.

The week ahead. We’ll continue to get more earnings reports in the week ahead, and attention will turn once again to Capitol Hill. Lawmakers didn’t solve the debt ceiling and budget crisis a couple of weeks ago. They just deferred it. Talks resume this week, though expectations on all sides are modest. Democrats and Republicans want to end the sequester, though Republicans are willing to tolerate it if it continues to whittle away at the size of government. The coming week won’t tell the tale on this debate, but it should give us more information about which way the political wind is blowing. And it should be entertaining to watch.