Are Stocks Now a Bargain?

 |  Includes: ALTR, DIA, IEF, NSM, PLL, QQQ, SPY, XLE
by: AAII

I have been looking at energy exchange-traded funds (ETFs) lately. Though I am disgusted with the oil spill in the Gulf of Mexico, I also realize that the problems with BP PLC (NYSE:BP), Transocean (NYSE:RIG) and Halliburton (NYSE:HAL) have caused prices of other energy-related stocks to fall. Plus, my first job in finance involved analyzing oil field companies, so I tend to keep an eye on the energy sector.

The problem is determining whether to trust the forward-looking valuations. The Energy Select Sector SPDR (NYSEARCA:XLE) trades at 12.2x forecast 2010 earnings. Though this seems pretty cheap, the valuation is dependent on forecasts being realized. Given the uncertain regulatory environment in the U.S. and potentially lower demand from Europe, there are reasons to take a step back and ask whether the price-earnings (P/E) multiple is reasonable.

I bring up XLE not as a reason to buy or avoid it – I tend to kick a lot of tires and, more importantly, you should always do your own analysis – but rather as an example of the conundrum that is facing the broad equity markets right now. There are questions as to whether full-year profit forecasts can be trusted given the debt problems in Europe, not to mention the uncertainty concerning financial regulation and, obviously, the energy sector.

Brokerage analysts have so far kept their profit forecasts for the S&P 500 essentially unchanged. Current forecasts predict earnings to total $79.48 per share this year. This consensus earnings estimate equates to a forward-looking P/E of 13.8.

Though the valuation appears to be cheap, it is important to remember that a low P/E does not make an index or a stock a bargain. Sometimes low valuations suggest concern about the future. Right now, that seems to be the case with the markets.

Whether the pessimism represents a buying opportunity or a sign to stay cautious remains to be seen. The bulls currently sure seem to be out to pasture, judging by some of the commentary about the markets I’ve been seeing lately. At the same time, the economic data still shows signs of a continuing recovery. One respondent to the May ISM manufacturing survey went so far as to say that he was seeing “no signs of the ramp-up abating anytime soon.”

Such mixed signals are not surprising given the current economic and geopolitical environment. In fact, a market correction, though unpleasant, helps to prevent irrational exuberance from forming. The key is to determine when a market correction provides opportunities and when it fails to cause prices to fall enough. Pessimism can bring opportunity, but you need to sort through a variety of tea leaves to figure out what sectors and stocks truly have attractive valuations.


Only three S&P 500 members are scheduled to report this week: Altera (ALTR – Monday), Pall Corporation (PLL – Tuesday) and National Semiconductor (NSM –Thursday).

The economic calendar is also light. The Federal Reserve’s Beige Book and April wholesale trade data will be published on Wednesday. Thursday features the April trade deficit numbers, in addition to weekly initial job claims data. May retail sales, the preliminary June University of Michigan consumer confidence survey and April business inventories will be released on Friday.

Federal Reserve Chairman Ben Bernanke and Richmond Federal Reserve Bank President Jeffrey Lacker will speak on Wednesday. Minneapolis Federal Reserve Bank President Narayana Kocherlakota and Philadelphia Federal Reserve Bank President Charles Plosser will speak on Friday.

The Treasury Department will auction $36 billion in three-year notes on Tuesday, $21 billion in 10-year notes on Wednesday and $13 billion in 30-year bonds on Thursday.