Take Some Profits While You Still Can

U.S. stocks are up 24% from their November low. Rejoice for a moment, but not two. Strong evidence suggests the recent rally is undeserved. Investors who six weeks ago were mourning their shattered "growth" stocks will want to use this reprieve to swap them for bottomed-out shares with safe dividends, and for a generous pot of cash.

Headlines are grim. Consider Monday's. Car makers said sales have plunged a third in a year. A pair of prominent economists said house prices won't bottom until 2010 and the unemployment rate will reach 11%, suggesting six or seven million more scrapped jobs. Crude oil, which had tumbled from $140 in July to $35 and change before Christmas, offsetting manufacturers' sales declines with reduced production costs, bubbled above $48 on Mideast mayhem.

But none of that matters if stocks are suitably cheap. If shares can be had now for 10 times earnings, and their long-term average is 15 times earnings, investors are getting a good deal, ugly headlines and all.

A quick look at earnings forecasts underlying the S&P 500 index, which tracks America's 500 largest public companies, suggest stocks are cheap enough. Wall Street's company analysts expect 2009 earnings to rebound 24%, to $81.80 per "share," if we consider the index itself a share. As such the index closed around $927 Monday, making for a price/earnings ratio of 11. But earnings will be half that amount, and stocks are thus twice as expensive as they appear, according to an alternative earnings forecast -- one that's more credible at the moment.

That aforementioned forecast of $81.80 has two main shortcomings. First, it's made from the estimates of analysts who track individual companies. They tend to be much slower than market strategists and economists to react to broad economic changes, since the latter make forecasts for entire industries. Second, the forecast ignores charges for things like layoffs, pension account losses and mark-downs for fallen asset prices. The trend of weeding out such items was born only over the past decade or so. The market's long-term P/E ratio of 15 is based on "as-reported" earnings, warts and all. If it weren't, historic P/Es would be much lower.

A more reliable forecast to use now, then, is one made up of the opinions of industry forecasters, and one that accounts for pending earnings charges. After all, S&P reckons companies in its 500 index have swung from a pension surplus of $63.4 billion to a shortfall of $257 billion over the past year. A Christmastime bill signed by the president eases requirements on when companies must shore up those accounts, but they will have to do so eventually, and the money they will spend is as relevant to stock investors as operating profits.

So what would earnings look like if we included the charges and listened only to industry forecasters? Fortunately, S&P tracks just such a number. It calls for 2009 earnings of $42.24, or about half the number most investors are watching. In November I noted that a wide spread between the two numbers suggested 2009 forecasts are due to fall. They have, but the spread has only gotten wider. "You could drive a truck through it, sideways," says Howard Silverblatt, senior index analysts at S&P.

Silverblatt notes that the higher number has been falling at an accelerated pace of late. In just over five months ended September 2008, the forecast fell by $9.44 to $103.86. In the final three months of the year it plummeted more than $22.

Bottom line: A stock market that looks to be trading at 11 times earnings is closer to 22 times earnings based on a more conservative measure. That's expensive, although not all stocks are due for a tumble. If you own high-expectations stocks -- ones with lofty price/earnings multiples, high anticipated growth rates and meager dividends -- trade them in for companies that are already trading below the liquidation value of their assets, and which pay big, affordable dividends. And make sure you have a year's worth of living expenses set aside in cash. If I'm wrong you'll miss out on a few percentage points of gains as stocks move to even loftier levels and dividend yields shrink again to much-lower-than-historic levels. If I'm right, your losses will be dampened when the market drops again, and your buying power afterward will be that much greater.

For some ideas on which stocks to favor, have a look here.