The stock market has seemed almost like an alternate reality so
far in 2013. The question for investors is whether they should buy
into the optimism of that alternate reality -- or heed the
warning signs from the rest of the economic
The S&P 500 rose by more than 6 percent in the first two
months of 2013. This rally occurred against a strange backdrop.
Early estimates of Gross Domestic Product (GDP) indicated that
economic growth virtually ground to a halt in late 2012. Meanwhile,
budget confrontations in Washington provided frequent reminders
U.S. budget deficit
was likely to be a drag on the economy for years to come. As if
that weren't bad enough, the contentious handling of the budget
created an atmosphere of uncertainty that discourages private
So which is right: the stock market or the grim headlines? One
way to approach that question is to look at the stock market in
greater detail. A look at earnings and dividends reveals some
things to like about the stock market -- and some things not to
What to like about the stock market
The price-to-earnings ratio.
At the end of 2012, the price-to-earnings ratio (P/E) of the
S&P 500 was at 16.21. With early 2013 rally in stock prices,
it had crept up to 17.22 by the end of February. That's not
cheap, but it's not terribly expensive either. Consider that from
the end of 1995 till late 2005 the S&P 500 went nearly 10
years without its P/E once dropping below 18. In fact, earnings
had just started to catch up with stock prices when the financial
crisis and Great Recession hit, knocking earnings back about a
decade. P/E is a good tool for putting stock prices into some
perspective. It measures the price you are paying for companies
relative to their ability to make money.
The dividend yield on the S&P 500 is a little above 2
percent. At a time when
savings account interest rates
are near zero and bond yields are below 2 percent, this makes
stocks a decent source of income. Just keep in mind, though, that
with stocks neither their value nor their dividends are
What not to like about the stock market
Flat earnings growth.
As the economy recovered from the Great Recession, trailing
12-month earnings on the S&P 500 grew by 51.76 percent in
2010, then by 12.41 percent in 2011, and most recently by 1.16
percent in 2012. That trend paints a picture of earnings growth
that is flattening out, which certainly doesn't support the
recent rise in stock prices.
The flattening of earnings growth is even more pronounced if you
look at operating earnings rather than reported earnings.
Fourth-quarter 2012 operating earnings were the lowest posted by
the S&P 500 since early 2011. This means that some of the
growth in reported earnings is due to accounting treatments and
extraordinary events and doesn't necessarily reflect anything
fundamental about the underlying business operations of companies
in the S&P 500.
Standard & Poors estimates that both reported and operating
earnings will see double-digit growth rates in 2013. If that growth
comes through, current stock prices will prove to have been quite
reasonable. If that growth stalls, however, the early-year rally
will only have increased the
risk of the stock market