Monday, June 11, 2007

Strong Market or Bubble, Part 2?

We're taking a deeper look at market valuations today, and helping us in that task are a few articles taken from the most recent Big Picture "linkfest". Thanks to Barry for posting and drawing our attention to them.

The first item we'll highlight is a Wall Street Journal article entitled, "Wealth Hazard: Guessing Low on Profit Growth".

In this piece, Justin Lahart takes a look at the earnings picture for U.S. stocks and finds that second-quarter earnings could benefit from strength in overseas businesses and continued share buybacks:

Companies in the S&P also bought back $110 billion of stock in the first quarter, Standard & Poor's estimates. That brought the total over the past four quarters to $442 billion -- enough to buy the bottom 100 companies in the S&P 500. Buybacks reduce the number of shares outstanding, lifting earnings per share.

Second-quarter S&P 500 earnings are expected to be up just 3.2%, but analysts might again be short of the mark. Strength overseas, dollar weakness and share buybacks are still potent forces -- as
International Business Machines demonstrated last week when it said it had spent $12.5 billion to repurchase shares. In a complex transaction, IBM used overseas earnings to finance the buyback at a low tax rate.

Lahart goes on to note that factors that have recently contributed to higher earnings, such as share buybacks, dollar weakness, and elevated profit margins, "tend to be highly cyclical".

While the market could continue to rally on the back of these trends, valuations in the S&P 500 are anything but cheap, as shown by Robert Shiller's analysis of average annual earnings over a 10 year period.

All in all, Lahart's piece seems to take a very balanced view of the U.S. market. The Journal doesn't want to douse the market's fire just yet, but they are reporting the skeptical view of what's happening with valuations.

On to the second article, in which Mark Hulbert asks, "Is It Just a Strong Market, or the Bubble, Part 2?".

Hulbert seems to be working from similar ground, as his article draws on some of the same arguments concerning valuations (and comment sources) as the Lahart piece. Hulbert adds to this discussion by examining some recent behavioral finance studies relating to investor sentiment and "bubble-causing behavior".

Tip: in the wake of a burst bubble, watch out for the consistently observed formation of "bubble echoes".

And in our third piece, Prieur du Plessis and his colleagues at Plexus Asset Management conduct their own study on S&P 500 valuations
(using data from Shiller and others) and find that the market is, "by historical standards, not in cheap territory", thereby signaling lukewarm returns ahead.

Finance Trends readers may have noted similar sentiments shared by me in recent posts & comments.