Bears Say The Darndest Things


A good investor considers the bearish case when he or she is bullish, and vice versa. Below are some of the more prominent criticisms of today's stock market, along with our take.

Stocks are ridiculously priced, with share prices unusually high relative to average annual earnings over the past 10 years.

Our take: The so-called Shiller P/E, based on 10-year average inflation-adjusted earnings for the S&P 500 Index, is above 26 — versus a norm of about 18 since 1946. However, the norm over the past 25 years is 25. More important, the ratio is high today because earnings have shown unusually strong growth over the past decade — not because stocks are expensive relative to trailing 12-month earnings. Based on the conventional trailing P/E, the S&P 500 Index trades in line with its 50-year norm.

The market is picked-over, with very few bargain-priced stocks.

Our take: As the table below shows, only 9% of S&P 500 stocks have a trailing P/E below 12, well below the norm of 16% since 1994. However, our growth-at-a-good-price approach does not depend on finding such deep-discount stocks, and the proportion of reasonably valued S&P 500 stocks is roughly in line with 20-year norms. As shown, 43% of S&P 500 stocks have P/Es below 18, versus a 20-year norm of 48%.

Per-share earnings are growing because of cost cuts and share buybacks, as revenue growth is anemic.

Our take: Some big-name multinationals delivered disappointing sales for the September quarter. But, as the table below shows, median year-to-year sales growth for all S&P 500 companies was 6.6% in their most recent quarter, above the 20-year norm of 6.1%.

As corporate profit margins have risen, so have price/sales ratios. When profit margins revert to historical norms, stock prices will suffer.

Our take: Profit margins for the S&P 500 Index have climbed to record levels. Because investors mostly care about earnings — and earnings have risen more quickly than sales — share prices are quite high relative to sales. In fact, the median S&P 500 stock trades at a price/sales ratio of 2.0 — above the 20-year norm of 1.5 and only slightly below the 20-year high.

The math is undeniable: If profit margins suddenly revert to historical norms, stock prices will take a big hit. But nothing says profit margins must begin reverting to historical norms right now — or ever. Several big cost drivers for U.S. companies — energy and commodity prices, interest expense, and taxes — seem unlikely to surge higher anytime soon.

Handicapping the other big reason margins are so high — the upper hand companies have over workers because of globalization and automation — is beyond the scope of this article. But investors will be watching wages closely as the U.S. labor market tightens, and a jump in wage growth is likely to prove better news for the American economy than for American stocks.

Our advice

Very few outright bargains are available, so you are probably better off looking for values among companies with decent growth prospects. PEG ratio (forward P/E to expected five-year profit growth) and P/E based on next-year expected profit have been two of the most effective variables in our Quadrix rating system over the past year, suggesting investors are willing to give companies credit for superior growth prospects but are wary of overpaying.

Nobody knows if these variables will continue to work in the near term, but you could do worse than bet on such growth-at-a-good-price standouts as Apple ($111; AAPL), Lam Research ($79; LRCX), and Magna International ($104; MGA). Our buy lists have 91% to 94% in stocks.

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