Dollars and Sense: Is the stock market over valued?

Are things really that good? It was another upbeat week in the stock market. Are things really that good, or are we whistling past the graveyard, in a state of serious denial? To take the premise of the question first: The markets rose again last week, and over the past month the Dow is up 1,500 points, or just short of 10 percent. It’s amazing to think that in February 2009 the Dow had dropped to below 8,000, and today it is within a few hundred points of 18,000. But it’s also true that the stock market growth has indeed outpaced the growth of the overall economy. Critics point out that artificially low interest rates and the government’s bond-buying scheme have inflated stock prices.

So are stocks overvalued? That depends on who’s doing the valuing. The current price-to-earnings ratio for the S&P 500 is just short of 20. That’s a bit on the high side. The historical norm is about 15, and that’s why lots of analysts still think we’re in for a 10 percent correction. But a reduction in price is only one way to bring the price-to-earnings ratio back to the historical mean. The other way is to increase earnings, and that’s what’s been happening in the markets. Thomson Reuters has been tracking earnings expectations versus actual performance since the early 90s, and its analysts tell us companies beat earnings expectations 63 percent of the time. You’ll sometimes hear market geeks call that the “beat rate.” This quarter, the beat rate is running more than 74 percent, and the beat rate has been above 63 percent every quarter this year. Strong earnings mean the higher stock prices we’ve seen are not unreasonable, and not caused by government stimulus alone.

Lifting all boats? It’s also a myth to say that a rising stock market doesn’t help middle Americans. Liberal critics of free markets and “Wall Street fat cats” say when the markets rise the rich get richer but the poor don’t benefit, or benefit as much. But that’s not true, either. To begin with, thanks to retirement plans, more than 50 percent of Americans own stock in some form, either individual shares or through mutual funds. So a vast number of Americans are benefiting directly from this rally. Those Americans who do not have stock portfolios still benefit, because when stock prices rise, the capital markets are more active. They create more jobs, start more new companies. That has created a virtuous cycle that has resulted in more than 200,000 new jobs being created every month this year so far.

What about the three E’s? If you’re a regular reader of this column you know that a few weeks ago I was concerned about the “three Es”: Ebola, Europe, and earnings. Earnings, as we just said, remain strong. The markets seem to think the Ebola crisis has moderated. Europe is still having problems, but it’s important to note we got some good news from across the pond last week. There were fears, for example, that Germany was sliding into a recession. New data out on Friday say that’s not happening, at least not yet. Spain’s unemployment rate is dropping. The European Central Bank has taken some dramatic steps to stimulate the economy there.

Oil prices. The continued drop in oil prices continues to make news. So-called Brent oil, which is the most watched price on the global markets, dropped to a four-year low last week, around $81 per barrel. West Texas Intermediate crude, the benchmark U.S. oil, is now at about $77 a barrel. Analysts say if West Texas drops another $10 a barrel, it could start having an impact on production.

China. New regulations and procedures in China will give global investors easier access to its $3.9 trillion stock market. Chinese shares jumped 2.5 percent and Hong Kong’s Hang Seng index climbed almost 1 percent on the news. China is the world’s second largest economy, and the fastest growing economy, so lots of analysts think its rise poses a threat to the United States. But these positive steps still leave China with a lot of problems. The markets have been showing renewed confidence in America. For example, since May the U.S. dollar has risen 12 percent against the major currencies. Most analysts think that’s a sign of continued confidence in the direction the U.S. economy is taking.

The week ahead. We’ll have a few stragglers report earnings numbers, and several of them will be from the key retail sector. Walmart reported a big jump in earnings last week and that not only sent its stock up 3 percent, it moved the Dow higher, too. We’ll also be getting a lot of economic reports from the government. The one most likely to move the markets will be the Consumer Price Index, which comes out on Thursday. There’s some disagreement about what a good CPI number looks like. Inflation has been very low for the past several years now. That’s normally a good thing, but deflation and perpetual 0 percent interest rates discourage borrowing and investment. So expect some wrangling in the markets when that number comes out, no matter what it is.