Exuberant "Delusion"?

Greenspan's model says market's overvalued again, unless '99 earnings soar

By Michael Santoli

Stocks went on sale for close to two months, but since then buyers have lined up so eagerly you'd think they were selling Furbys (this year's hottest toys) instead of equities on Wall Street, creating a sort of inflation that Alan Greenspan takes particularly seriously. That's what might be inferred from the "Greenspan model" of stock-market valuation. Propagated by Deutsche Bank Securities chief economist Edward Yardeni, who spotted it deep in a Federal Reserve document, the model compares the "earnings yield" on Standard & Poor's 500 stocks to the yield on 10-year Treasury notes. And right now, after skidding fast to an undervalued level in September and October, the market has raced to a state of 10% overvaluation even more quickly.

The logic behind the indicator holds that investors are unlikely to bid stocks much higher if they are returning less in terms of earnings than the government is paying on risk-free bonds. So, whenever the earnings yield -- that is, forecast profits for the next 12 months, divided by the S&P 500's value -- dips below that of 10-year rates, the market is said to be overvalued, and vice versa.

That panicky investors drove stocks below "fair value" in early fall no doubt helped solidify Greenspan's move to surprise the market with a second rate cut October 15, which, of course was followed by a third reduction this month. But the Fed also noted with its three quarter-point cuts in the key overnight federal funds rate, to 4 3/4%, "financial conditions can reasonably be expected to be consistent with fostering sustained economic expansion." In other words, with the S&P making a new high less than a week after the Fed's latest cut, Greenspan & Co. no longer are losing sleep over a bear market in stocks.

That the equity market is 10% overvalued after its recent rebound, however, isn't in itself a clear signal of impending doom. The model has been a pretty good gauge of the market's general direction for nearly two decades, but as Yardeni notes: "It's usually only when you get to 20% or 30% overvalued that you're really asking for trouble."

And markets can remain out of whack for a long time. Indeed, when Barron's last highlighted this valuation method in March, the market was about 18% overvalued with the S&P 500 at 1068, but stocks continued to power higher into the summer until peaking July 17 with the S&P at 1187 -- very close to its current level. One pitfall in relying on this Fed model, though, is that it's only as accurate as the earnings forecasts that underpin it. And Yardeni, for one, believes projected 1999 earnings "are way too high. They're delusional." To him, this means "the market is grossly overvalued."

Currently, says Joe Abbott of I/B/E/S, which tracks analysts' expectations, S&P 500 earnings are forecast to be $52.95 a share in 1999, up an astounding 17% from the current 1998 estimate of $45.08. That suggests that analysts are crunching their numbers with rose-colored eye shades. Consider that in March 1998 earnings were projected to be $50.78, a whopping 11% higher than they now figure to come in.

Also ominous is the fact that in October and November, those 1999 forecasts were coming down. When published estimates also drifted lower in February and March, it was the first time that had happened in years, and Abbott figures that 1998 is the first year that forward estimates have declined so steadily since 1991-1992. Even if Corporate America somehow rises to the challenge and meets Wall Street's lofty target for 1999 profits, the market is still now trading at 22 times next year's earnings, which translates to an earnings yield of 4.45%. Not exactly a bargain, with the 10-year Treasury yielding 4.80%.

The "Greenspan model" clearly signaled a market top earlier this year and is again showing stocks to be overvalued. And if earnings fail to hit current forecasts, watch out.

Even the most bullish of stock watchers aren't getting behind that 17% earnings-growth target. Thomas Galvin, chief strategist at Donaldson Lufkin & Jenrette, is holding to his bold calls of a rise in the Dow Industrials to 11,000 and in the S&P 500 to 1300 by the end of next year, and he certainly is among the most sanguine on Wall Street in his outlook on big-company earnings. But his optimism is producing a forecast of 1999 earnings that stops short of 17% growth, coming in at 13% over an above-consensus 1998 estimate of $45.90.

He hangs his upbeat view on a few specific hooks. First, he contends, a series of one-off factors have made even this year's earnings look weaker than real core results. The GM strike spurred big losses that aren't expected to recur. And the historic seizing up of financial markets made for billions in losses for banks and other financial companies. Meanwhile, the erosion in oil prices flattened energy companies' results. Excluding GM, financial companies and energy producers, Galvin calculates that what appeared to be a 3% drop in third-quarter earnings turns into a healthy 9.4% climb.

Of course, it's no trivial adjustment to exclude companies worth close to a quarter of the S&P's market value. But last week a number of bulls -- insistent that the glass was half, if not three-quarters, full -- were indeed pointing to the easier earnings comparisons many companies will enjoy in 1999 as reason to continue buying stocks.

Galvin has other, forward-looking reasons for his bright expectations as well. A likelihood of a flatter or weaker dollar as the euro debuts and Japan shuffles toward financial reform should bolster the earnings of the big multinationals that dominate the major stock indexes. The global credit crunch could let these American giants, with their abundant capital and technology, expand overseas on favorable terms. And in Galvin's most iconoclastic prediction, he ventures that all the spending to fix the Year 2000 computer glitch will throw off nice efficiency gains for big companies.

Could happen. Yet, even if all these scenarios click in to place and S&P 500 companies heroically manage to hit the high end of Galvin's earnings-growth range of 12%, it still makes for a less-than-irresistible market valuation of close to 23 times 1999 profits.

And what if money managers turn out to be right in their tamer hopes? A DLJ survey of buy-side managers revealed a consensus 1999 earnings view of either a slight decline or a rise of less than 5%. Even assuming a 5% climb means the S&P is at a historically high 25 times earnings and the Greenspan model would put the market near the danger zone of 20% overvaluation.

All of which suggests it's unlikely Greenspan himself would be buying stocks -- or bailing out the market again with more rate cuts any time soon.