Missing the Trees for the Forest – Look at Individual Stocks

Monday, November 16, 2009

990904_focusI just read that stocks are overvalued. The proof? The forward price/earnings ratio (P/E) for the Standard & Poor’s 500 Stock Index (S&P 500), now about 17 times, is at the high end of its historical range. [“Forward” means the “E” is estimated future earnings.] At this point in the economic and financial cycle, such amalgams as the S&P 500 can be misleading. We need to look at the components – the individual companies and stocks. Here’s why…

The old saw is, “It is not a stock market; it’s a market of stocks,” is especially relevant today. There are too many economic crosscurrents and too much industry and company differentiation right now. While earnings, overall, are expected to improve, there are large groups that will still be below normal (think financial companies and heavy industry). So, large, composite measures, like the S&P 500’s forward P/E, can be misleading.

It’s why I have been focusing on the Dow Jones Industrial Average (DJIA) and its 30 high quality companies. These diversified blue chip stocks can give us the picture we need – both earnings expectations and common stock valuations.

Last month, I wrote, “It’s Time To Watch the Earnings Reports.”  We are almost at the end of the October/November reporting cycle for the DJIA companies. After Hewlett-Packard reports on November 23, I will explain what we can glean from the 30 reports, particularly about growth expectations and valuations.

Here’s an inkling: the news is good. Earnings forecasts are picking up, and valuations remain attractive. Currently, the average forward P/E for the 30 DJIA stocks is about 14. Only five stocks are above the S&P 500’s 17 average: American Express (17.2), General Electric (17.4), Bank of America (18.6), Alcoa (22) and Caterpillar (22.4). No surprise there. These “high” measures reflect below normal earnings (the E), not stock market overvaluation (the P).

So, ignore for now generalities based on stock market measures. Look instead at individual stocks to get at meaningful expectations and valuations.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

November 2009