Are stocks cheap yet? Not if the economy is slowing, these numbers say

Trying to figure out whether the U.S. stock market after the stunning decline of the last month is a bargain or not?

James Mackintosh’s “The Short View” column in today’s (August 23) Financial Times lays out in very clear terms one way to answer the question.

After a month of selling the Standard & Poor’s 500 Stock Index trades at just 10.3 times projected earnings. That’s below the forward price-to-earnings ratio in March 2009, the post-Lehman Brothers bottom. (The average since 1985 is 15.)

But that’s only cheap, Mackintosh points out, if projections for future earnings are accurate.

Right now forecasts by Wall Street analysts are calling for earnings of $108 a share for the 500 stocks in the S&P index. That’s higher than earnings on the index in 2007.

But in 2008 forecasts (and then actual earnings) plunged as the economy fell into recession.

A similar drop to that from 2007 to 2008 in today’s forecast earnings—which is what investors could expect if the U.S. economy dipped back into recession–would put the S&P 500’s price to earnings ratio at 17. That’s not cheap but rather expensive in comparison to the long-term average of 15 since 1985.

A 20% drop in forecast earnings—the rough equivalent of an economic slowdown instead of a recession—would put the price-to-earnings ratio of the S&P 500 at 13. That’s below the average of 15 but not really very cheap given the degree of economic risk that an investor is taking on right now.

Today’s rally in Japan on news that could have been worse suggests stocks may have fallen too far

Here’s the question that global stock markets are grappling with now: If global economies are slowing, stocks should get marked down in price. But by how much?

This morning’s economic data from Japan and the reaction of the Tokyo stock market suggests that the August sell-off may have gone a bit too far.

The news certainly wasn’t good from Japan. Gross domestic product fell at a 1.3% annualized rate in the second quarter.  That’s the third consecutive quarterly decline: Japan is most definitely back in recession.

But GDP fell more slowly than the 2.5% drop projected by economists as spending on reconstruction efforts after the March earthquake and tsunami started to offset some of the damage from the event itself and a slowing in exports caused by a stronger Japanese yen.

On the news the Nikkei 225 stock index was up 1.4% as of the August 15 close in Tokyo. Read more

At the moment U.S. Treasuries are the safe haven of choice.

And so, strange as it may seem, is the U.S. dollar.

Let’s take the currency piece of this first. The U.S. dollar is up against strong currencies such as the Canadian and Australian dollar, and the Swiss franc. The logic on the Canadian and Australian currencies is that a slowing global economy will hurt these commodity-exporting economies enough to end any prospect of interest rate increases. In the case of the Swiss franc the concern seems to be that the Swiss central bank has decided to intervene to weaken the currency in order to save the country’s exporters from further pain.

The dollar is still expected to decline by the end of the year with Wall Street investment strategists surveyed by Bloomberg predicting a 1% decline in the currency in the fourth quarter. But that’s a huge shift from the results of Bloomberg’s July 12 survey when strategists were projecting a 2% decline.

In the bond market, U.S. Treasuries remain the favorite bet of investors fleeing volatility in global financial markets. The Federal Reserve’s promise last week to keep interest rates at their current extraordinarily low levels through 2013 was an open invitation to use Treasuries as a shelter from risk. After all, the Fed’s statement removed any risk to Treasuries from an increase in interest rates.

Last week Treasury prices rose and yields on the 10-year Treasury fell to a record low of 2.0346% on August 9. Even the U.S. Treasury’s auction of $72 billion in notes and bonds wasn’t enough to move yields significantly higher.

The next event that has the power to change the balance in the currency and bond markets is the Tuesday, August 16, meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel. Topic A, B and C will be how to stabilize the euro and European financial markets. Last week France, Spain, Italy, and Belgium all imposed bans on short selling. Such a ban smacks of panic and while the markets may welcome any stability the move brought to shares of hard-hit European banks, investors are now looking for some assurance that the ban is only a temporary measure set to be replaced by a long-term plan for the euro.

Update Itau Unibanco (ITUB)

Want to know why Brazil’s stock market was the first global market to fall into a bear? You can see the reasons for the fears that have been crushing Brazil’s stocks in the August 3 earnings report from Itau Unibanco, for my money Brazil’s best-run bank. (Itau Unibanco is a member of my Jubak Picks 50 long-term portfolio http://jubakpicks.com/jubak-picks-50/ )

The company announced that for its second quarter net income climbed 14% from the first quarter in 2010. Adjusted earnings per share, which exclude one-time items, were 73 centavos a share. Analysts had been expecting adjusted earnings per share of 82 centavos so the bank missed estimates by almost 11%.

The problem with the quarter wasn’t loan demand. Read more

I don’t think stocks have broken their long-term upward trend but that’s a worry that means this market will take a while to base

You’ll be hearing a lot of talk over the next days and weeks from the technical analysts about the damage that’s been inflicted upon the condition of the markets. That’s one reason, they’ll say, that this market won’t bounce back immediately from its extremely oversold current condition and begin a new rally.

But what does that mean when you translate it?

Actually, it’s pretty straightforward. What the technicians are saying is that the market’s plunge has taken stocks down to levels that make it hard to tell whether this is a short-term correction in what is still a market that is trending upward in the longer term or if this drop has broken the longer-term upward trend and the market is about to drop further.

For a while it was possible to believe that this decline would take the Standard & Poor’s 500 back to its November 2010 lows near 1170. Read more