Low Prices for Profits

Continuing its high-level holding pattern of the past three months, the Dow Jones industrial average last week came close to a three-year high of 1011 before settling back a bit to close at 992.6, down 3.62 for the week. But by several other measures the market is not particularly high at all--nor has it risen fast enough this year to make many investors feel rich. For example, a recent compilation by Smith Barney, Harris Upham & Co., a Manhattan brokerage firm, shows that 80% of the stocks on the New York and American exchanges are selling for $25 a share or less, an only slightly smaller proportion than in January, when the Dow began its powerful assault on the 1000 mark. And price/earnings ratios. one of the most critical of all market measures, tell a story of even less ebullience.

A P/E ratio is calculated by dividing a company's profits per share for the most recent four quarters into the price of its stock. Thus if a company earns $5 a share and its stock sells for $50, its P/E is 10. P/E ratios vary wildly from stock to stock, based mostly on how rapidly investors think a company's profits might rise. In general, however, P/Es are still far below their peaks of the recent past, and they have not risen much this year.

As late as January, 12.2% of all stocks on the New York and American exchanges were selling for less than five times earnings. Now only 9% are--a slight improvement. But the proportion of stocks selling for more than 20 times earnings has actually dropped since January, from 18.2% to 16.7%. The 30 Dow Jones industrials now sell at an average P/E of 13.1, up from 12.9 at the start of the year but well below the 1971 high of 17.3.

The relatively low P/Es testify to a dominant conservatism among investors that stands in welcome contrast to the giddy atmosphere of the late 1960s and early '70s. For years before that, Wall Streeters thought that a P/E of 10 to 15 was normal for most companies. But as the economy rolled through the late 1960s without recession, investors got the naive idea that profits, particularly of some growth or "glamour" companies, would keep on rising rapidly forever--so that almost no price was too high to pay for the prospect of sharing in future earnings. Before the crash came in 1973-74, P/E ratios of growth companies had been bid up to stratospheric levels that the Dow Jones P/E average never came close to matching. One index of 15 glamour stocks hit an average P/E of 47.4 at the end of 1972; two years later it was down to 14.7, and it has now recovered only to 21.2.

More striking still is the contrast between the onetime peak and present P/Es of some individual stocks. Samples: Polaroid, a high of 114 v. 18 now; McDonald's, 81 v. 26; Xerox, 63 v. 16. At one point in 1968, IBM was selling at $701.50 a share, or 161 times earnings, giving its stock a market value equal to all the shares in all the oil companies in the U.S. Now, at $256 a share, IBM is priced at a modest 18 times profits.

To optimistic analysts, the present conservatism of P/E ratios indicates that the current bull market is only in its early stages and many stocks are still undervalued. Since corporate profits are widely expected to rise 25% to 30% this year, stock prices could go up considerably even if P/E ratios hold unchanged. There appears to be room for some rise in the ratios themselves too. But P/E ratios will not soon return to the heights of the early '70s.

Hot Issues. Small investors generally have greeted the market rise with a yawn, and left trading to the big institutions (mutual funds, pension funds, trusts). In mid-May, small investors (those who trade in lots of 100 shares or fewer) sold 250 shares for every 100 they bought. The speculators, who in the 1960s bought "hot issues" selling at high P/E ratios, now are trading instead in options, or the right to buy or sell stock at a specified price in the future.

As for institutional money managers, many have nightmare memories of being stuck with blocks of stock bought at high multiples of earnings that they could unload only at a drastic loss. Some institutional analysts now question whether any stock should ever sell at a P/E higher than 25, however bright the company's prospects.

Generally the institutions are putting their money into the stocks of "smokestack America"--basic-industry companies that have good dividend records and modest P/Es.

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