After a big rally, stocks aren’t looking so cheap

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Your equity portfolio may be down more than 40% in the last year and a half, but that doesn’t mean stocks are cheap.

The powerful rally that has carried the major indexes up more than 30% since early March has pushed valuations up to levels that could disrupt -- or at least stall -- the upward march.

The median price/earnings ratio of stocks in the Standard & Poor’s 500 has averaged about 18 since 1988, based on operating earnings over the preceding 12 months, according to S&P.

That ratio now stands at 22 -- a warning sign that there may not be much room left for additional short-term gains, said Sam Stovall, S&P’s chief investment strategist.

Investors have piled into the market as evidence has suggested that the economy is out of its free-fall, and that actual growth -- albeit tepid -- may be within sight. But if that scenario doesn’t play out on schedule, the stretched valuations could leave the market vulnerable, Stovall said.

“Investors have faith that this time around, stock prices are correctly anticipating the end of this recession and recovery not only in economic growth but also in corporate earnings,” Stovall said. “This might work out, but it’s getting increasingly difficult to justify it based on valuations.”

The rally continued Tuesday on a better-than-expected report on consumer confidence, but stocks fell back today on a surge in Treasury yields driven by concerns about a flood of newly issued government securities.

One reason the stock market already appears pricey, Stovall said, is that it never got that cheap.

The S&P’s operating P/E fell no lower than 16 at the stock market’s trough. Helping keep the ratio up was a first-ever decline in S&P 500 operating earnings in the fourth quarter, exacerbated by billions of dollars in asset write-offs by troubled banks.

Stocks seem more reasonably priced based on forward-looking earnings -- but still aren’t a tremendous bargain.

The P/E is 16.4 based on projected 2009 profits, and about 12 based on 2010 numbers. Using this year’s estimates, the priciest sectors are financials at 51, consumer discretionary at 48 and materials at 34, Stovall said.

Some investors are skeptical of forward P/Es these days, given the cloudy economic outlook. Analysts were forced to repeatedly lower their estimates in the last year as the extent of the recession became apparent.

“What valuations are saying is: Don’t expect the next two months to be as positive for equity prices as the last two months,” Stovall said.

-- Walter Hamilton