Not Ugly Enough

By Daniel Kadlec

So, are stocks cheap yet? Clearly, they're cheaper than they were two weeks ago. But are they Russian-ruble cheap? So ugly that they scare the dog? The answer depends largely on whether you believe that interest rates will fall further and corporate earnings will hold up in the face of Asia's spreading ills. A quick scan of Wall Street illustrates the debate. At Paine Webber, chief strategist Ed Kerschner holds the rosy view that stocks "have not been this cheap since October 1990." Chief guru Abby Cohen at Goldman Sachs similarly says, "Stocks are trading at undervalued levels." But at Morgan Stanley Dean Witter, chief strategist Barton Biggs insists that "we are either in or on the verge of a bear market." And the wily investor Larry Tisch at Loews Corp. just reconfirmed a massive options bet on lower prices.

As usual, the best advice for individuals is to listen to these mixed signals for sport, and then do nothing. Over the long term you'll be best served by investing a few hundred dollars in stocks each month no matter what the market does. But it never hurts to look for bargains, and if you're a mutual-fund investor, it may help to check the pulse of the overall market.

So let's survey the bidding. The market low (based on closing prices) for the past five months was reached Friday. The average NASDAQ stock was down 39% from its 52-week high, and the average stock on the New York Stock Exchange was down 30%, according to Salomon Smith Barney. The average decline in stocks of very small companies (market value under $250 million) was a staggering 47%. Those are major losses, masked by the more visible Dow decline of just less than 10%.

Despite the bloodletting, though, traditional measures still show the market to be more expensive than at any time before the current cycle. The S&P 500 dividend yield, which stood at 2.6% on the eve of the 1987 crash, has dropped to 1.5%. The S&P's price-earnings ratio, or P/E (based on expected earnings), is 21--down from 23 in July but still much higher than the previous peak of 19 in 1991, according to earnings tracker First Call. Meanwhile, market leaders still sport bubble-like P/Es: Coca-Cola, where unit sales are growing about 8% a year, has a P/E of 51. Microsoft's is 63; Cisco Systems', 78. High-flying Internet stocks have no P/E because they have no "E." Yahoo, the Net-search directory, trades at 73 times revenue. The comparable multiple for Coke is 10.

Low inflation and interest rates help explain these valuations. But even the trusty "rule of 20," which takes inflation into account, has been trashed. The rule holds that the market P/E plus the rate of inflation should total about 20, as it has for most of the past 40 years. With inflation running at 1.7%, today's reading is 23, and when calculated using reported rather than expected earnings, it jumps to 29--well above the 26 reached on that basis just before the 1987 crash, notes analyst Richard Bernstein at Merrill Lynch.

This doesn't mean there are no cheap stocks. Take out the 50 most popular stocks in the S&P 500, and the average P/E of the rest falls to a not-so-scary 18, according to Morgan Stanley. And there are hundreds of smaller stocks with P/Es below their expected rate of earnings growth--a classic sign of value. But the overall market will not be cheap by historic standards unless the S&P falls 40%--or its underlying companies earn far more than analysts project.

See time.com/personal for more on cheap stocks. E-mail Dan at [email protected] See him Tues., 12:40 p.m. E.T., on CNNfn.