Have stock prices raced ahead of reality? Maybe not

As the stock market powers ahead again, many nervous investors are asking themselves if shares are now overvalued. The Dow Jones and the broader S&P 500, after all, are now up more than 50% off their recent lows and picked up again this week.

For many bears caught off-guard by the sharp upturn, like Gluskin Scheff analyst David Rosenberg, the answer is obvious: Stocks have again reached valuations not seen since the Internet bubble. But it's not that easy.

After facing the worst recession and financial catastrophe in decades, the stock market may be justifiably anticipating better times ahead. And given the backdrop, focusing entirely on the last year's results isn't just like driving by looking in the rearview mirror -- it's expecting a roadblock ahead because of the massive pileup behind.

Bears like to point out that stocks are trading far above their historical averages by some measures. At 27.3, trailing 12-month operating income for the S&P 500, for example, is well above its more usual level of about 15. But a look at the operating income that analysts forecast for 2010 shows that the index is trading largely in line with historical averages, says Howard Silverblatt, a senior index analyst at Standard & Poor's.

That view assumes a sharp 33% yearly jump in earnings, even as the economy continues to wrestle with major issues like massive unemployment and the aftermath of a housing bust. But given where the markets are coming from, that isn't such a stretch. Recall that just a year ago, major banks like Lehman Brothers were failing and a paralyzed credit market was leading iconic companies like AT&T (T) to complain they were having trouble getting more than overnight loans.

"All the Gears Closed"

Companies in the S&P index saw their worst earnings period in history during the fourth quarter last year, Silverblatt says, and the credit evaporation that was then spreading had disastrous consequences for business. "The credit crunch was a killer because credit greases the wheels of everything, and it means all the gears closed."

Fearing a replay of the Depression, many companies cut costs to the bone, some analysts have argued. But that means even a small pickup in business can have a big impact on profits -- and indeed margins showed significant improvement this quarter, Silverblatt points out.

As a result of the sharp cost cuts like massive layoffs and inventory reductions, companies are now sitting on huge piles of cash. Along with that cash sparking a boom in mergers -- which also helps boost the market -- signs are emerging that companies are now preparing to embark on a new spending cycle.

A survey of big European companies by investment bank Credit Suisse (CS) showed that two-thirds planned to maintain or increase their spending over the coming year, compared to just 6% in the past year. "The message was unambiguous -- the tide is turning in corporate spending," analysts wrote in a report on Friday.

Of course, major problems still linger, and the markets are unlikely to reach new all-time highs, as some outrageously bullish investors have predicted. But if a solid economic recovery materializes -- as more Wall Street stalwarts are now predicting -- the market appears to have the earnings it needs to hang on to recent gains.

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