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Buying stocks now may be less risky than you think

Monday - 3/11/2013, 8:30am  ET

BERNARD CONDON
AP Business Writer

NEW YORK (AP) -- Is it too late?

If you've stayed out of stocks recently, you might be worried that you've missed your chance to get back in. After all, they must be expensive now that the Dow Jones industrial average has risen 120 percent in four years to a record high.

The good news is that stocks still seem a good bet despite the run-up. The bad news: They're no bargain, at least by some measures, so don't get too excited.

Many investors obsess about stock prices. But you must give equal weight to a company's earnings. When earnings rise, stocks become more valuable -- and their prices usually rise, too.

That seems to be happening now.

"We've had record profits upon record profits," says John Butters, senior earnings analyst at FactSet, a research firm. "And estimates are we'll have record profits this year, too."

What's more, some of the typical threats to stock run-ups -- such as rising inflation and interest rates, which often trigger a recession -- seem unlikely to appear soon.

Among reasons to consider stocks again:

-- A STRONGER ECONOMY:

There are no signs of a recession. And that's encouraging for stocks, which almost always fall ahead of an economic downturn. Stocks started falling two months before the Great Recession began in December 2007 and one year before the recession that started in March 2001.

Better yet, the economy may be on the verge of faster growth. The Labor Department announced Friday that the unemployment rate in February dipped from 7.9 percent to 7.7 percent, its lowest level since December 2008. Employers added more than 200,000 jobs each month from November-February, compared with 150,000 in each of the prior three months.

More jobs mean more money for people to spend, and consumer spending drives 70 percent of economic activity.

And there has been a flurry of other hopeful signs lately. Homebuilders broke ground on new homes last year at the fastest pace in four years. Sales of autos, the second-biggest consumer purchase, are at a five-year high.

If recent history is any guide, this economic expansion is still young. The expansion that began in June 2009 is 44 months old. The previous three expansions lasted 73 months, 120 months and 92 months. Corporate earnings grow in expansions, which can push stocks higher.

In the 1982-1990 expansion, earnings of companies in the Standard and Poor's 500 stock index grew 50 percent, according to S&P Dow Jones Indices, which oversees the index. The S&P 500 itself surged nearly 170 percent.

For 2013, earnings of S&P 500 companies are expected to grow 7.9 percent, then jump another 11.5 percent next year, according to FactSet. If that's right, stocks could rise fast.

But history offers three caveats: First, if you look at the 11 expansions back to World War II, instead of the last three, they last 59 months on average. By that measure, the current expansion is middle aged, not young.

Second, investing based on U.S. economic expansions may not work as well as in the past. Big U.S. companies generate nearly half their revenue from overseas now so you need to worry about other economies, too. The 17 European countries that use the euro as a currency have been in recession for more than a year. Japan, the world's third largest economy, has struggled to grow.

If the worst is over for these countries, U.S. stocks could continue rising. If the growth drags, stocks could fall.

Third, earnings forecasts are often too high. They come from financial analysts who study companies and advise on stocks to buy. In the past 15 years, their annual earnings forecasts were an average 10 percent too high, according to FactSet. Last year, they got closer: They overestimated by 4 percent.

-- STOCKS REASONABLY PRICED:

Investors like to use a gauge called price-earnings ratios in deciding whether to buy or sell. Low P/E ratios signal that stocks are cheap relative to a company's earnings; high ones signal they are expensive.

Right now P/E's are neither low nor high, suggesting stocks are reasonably priced

To calculate a P/E, you divide the price of a stock by its annual earnings per share. A company that earns $4 a share and has a $60 stock has a P/E of 15. Most investors calculate P/E's two ways: based on estimates of earnings the next 12 months and on earnings the past 12.

Stocks in the S&P 500 are at 13.7 times estimated earnings per share in 2013. That is close to the average estimated P/E ratio of 14.2 over the past ten years, according to FactSet. The P/E based on past earnings paints a similar picture. The S&P 500 trades now at 17.6 times earnings per share in 2012, basically the same as the 17.5 average since World War II, according to S&P Dow Jones Indices, which oversees the index.

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