The Economy

Peter R. Crabb: Eyeing the stock market? Here’s some food for thought

PETER R. CRABB, professor of finance and economics at Northwest Nazarene University in NampaOctober 29, 2013 

Peter R. Crabb

With the risk of a government default past us for now, is it a good time to buy stocks? The economic answer to this question is: It’s all relative.

This year, investors have been encouraged by a pick-up in earnings for U.S. stocks. The Dow Jones Industrial Average, at around 15,000, is up more than 14 percent on the year. The NASDAQ Composite index is more than 25 percent higher.

With such a good run-up in prices, it’s easy to think stocks are overpriced. But stocks are very difficult to value. Unlike bonds, where returns are known by the bond’s yield to maturity, identifying the return on a stock is hard to come by.

A common estimate, popularized long ago by investor Benjamin Graham, is found by comparing net income for the company to the price of its stock. This rate is the inverse of a stock’s price-to-earnings (PE) ratio.

At current prices, the average large-company stock has a PE ratio of 14, or an earnings yield of 7.1 percent. This rate of return is about three times what investors can expect to earn on safe U.S. Treasury bonds, and double the yield to maturity on investment-grade U.S. Corporate bonds.

Two stocks of interest to Idaho investors match the market in terms of earnings yields. Micron Technology’s PE ratio right now is near the market average of 14, up from 7 two years ago. As reported in the Statesman, Micron’s net income was positive for the past two quarters following two years of losses. The company’s growth prospects are improving with the acquisition of Elpida. Idacorp Inc., parent of Idaho Power, has a PE of 13.7 and an earnings yield of more than 7.2 percent. The earnings yield on this regulated utility stock has consistently been better than bonds.

By these measures, stocks look like a pretty good deal, but economists don’t necessarily agree on how well the stock market values companies that trade there. This disagreement is evident in the announcement for the 2013 Nobel Prize in Economics.

Eugene F. Fama, Lars Peter Hansen, and Robert J. Shiller received this year’s prize for their research on financial asset prices. The Nobel committee said the economists “laid the foundation for the current understanding of asset prices.”

Interestingly enough, however, professors Fama and Shiller interpret stock market data differently. Fama is best known for research showing the financial markets are efficient and current stock prices reflect relevant information. That is, stock prices are unpredictable. Shiller’s economic research was popularized in his book “Irrational Exuberance,” where he suggests stock prices can deviate from true value and predictions over longer periods are possible.

Investors shouldn’t expect economists to give them a perfect model of stock prices. Whoever created such a model wouldn’t tell others, just use it to make money.

Lacking a definitive model of how to price stocks, investors are best served remembering the economic principle of relative value. The true value of anything we buy is the alternative we forego with the purchase.

The most direct alternatives to stocks are bonds. The low rates or yields on bonds today means stocks are the relatively better deal.

With this good deal comes risk. We can never know what stocks will earn in the future. That’s why they say, “no risk, no reward.”

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prcrabb@nnu.edu

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