Bargain-basement stock prices? Handle with care

A trader works on the floor of the New York Stock Exchange, October 23, 2008.

NEW YORK (Reuters) - Every prospective investor has heard this line in the past month: The historic selloff in U.S. stocks has left them bargain-basement cheap.

But -- as your mother warned you about outrageous bargains -- if it looks too good to be true, that's because it is.

A key benchmark for measuring equity valuations -- the forward four-quarter price to earnings ratio for the S&P 500 -- currently stands at 9.8, according to Thomson Reuters data. Not only does that suggest stocks are roughly 35 percent less expensive than their historical average of 15 times forecast earnings, it makes them the cheapest since 1984.

Investors should be salivating over such a once-in-a-generation opportunity to get stocks at so deep a discount.

Here's the problem: Wall Street analysts and strategists have yet to get their arms around the deteriorating outlook for a year from now. Once they do, the current estimate for S&P 500 companies as a group to generate $91.15 per share profit over the next four quarters -- the highest ever forecast -- will almost certainly plummet and undermine the stocks-are-cheap thesis in the process.

"At this point we are very suspect of analysts' earnings estimates and stock prices in relation to them," said Cleveland Rueckert at Birinyi Associates Inc in Stamford, Connecticut.

Most analysts are barely keeping up with the deteriorating profit scene being reported now by U.S. companies for the just-completed third quarter, which is shaping up as the fifth straight quarter of declining earnings. In fact, current estimates suggest a big profit recovery starting in the fourth quarter, even as economists forecast another drop in quarterly gross domestic product.

That disconnection helps feed the investor doubt hanging around stocks.

"First off, fundamental analysts proved themselves to be very unreliable when it came to estimating earnings for financial companies," Rueckert said. "Second, investors seem to be less willing to bet on earnings in the current market."

In other words, P/E ratios of 7 to 8 seem more likely going forward than higher multiples of 20 to 30, Rueckert said.

That's not to say there are no bargains to be had -- but it's a question of an investor's time frame.

Between 1977 and 1982, for example, stocks stayed put at forward P/Es in single digits, according to Thomson Reuters data.

Another complication is that a number of companies are refraining from giving outlooks for 2009, as uncertainty about the myriad of measures being taken globally to combat the credit crisis combines with a global economic slowdown to produce an unusually foggy picture.

"The problem with forward P/E is that you know what the price is, but you don't know what the 'E' will be," said Richard Sparks, senior equities analyst at Schaeffer's Investment Research in Cincinnati, Ohio.

"Some people might say that the forward P/E is relatively cheap here, but if earnings come in a lot lower than expected, then that statement is no longer accurate."

LET HISTORY BE YOUR GUIDE

The key is, of course, how much of an earnings downturn has already been priced in to stocks. This week a number of companies disappointed the market with earnings and outlooks -- and their stocks fell.

Given the fogginess of the earnings outlook, trailing, or historical, price-to-earnings multiples may be a better indicator of how much has been priced in to stocks, analysts said.

Subodh Kumar, chief investment strategist at Subodh Kumar & Associates in Toronto, calculates that at a level of around 900, the S&P 500 has likely priced in an earnings decline of 35 percent from the peak operating earnings of $87.70 per share at year-end 2006. That would be the second-worst decline ever -- paling only in comparison to a decline of 75 percent in 1929 to 1933 from which earnings took 15 years to recover, he said.

In 2000-2002, the earnings decline was 25 percent from the peak, and then recovered within 3 years.

So how low might valuations go before stocks' downward trend ends?

Justin Walters, a co-founder of research firm Bespoke Investment Group noted that the current trailing 12-month price to earnings ratio of 19.2 is still well above the average P/E at the end of bear markets of 12.7, dating back to 1946.

And while in an average bear market P/Es usually drop by 5.84 points, the current bear market has seen P/Es fall just 0.39 point so far, according to Bespoke's data.

"The issue today is how long beyond 2009 recovery takes," said Kumar.

It will depend on "whether the government and Federal Reserve's capital intervention help or hinder recovery and if company guidance suggests management is proactively dealing with the undeniable slowdown, or is giving a sense of flailing about in debacle."

(Reporting by Kristina Cooke; Editing by Kenneth Barry)