Why Stocks Aren't Cheap

The great thing about statistics is you can twist them in any manner you want to make your point. In a recent post on the online version of The Wall Street Journal, hedge fund manager James Altucher did exactly that, when he argued that stocks are cheap right now. Now it's my turn.

Altucher basically argues that the U.S. economy is growing, so fears of a double-dip recession are incorrectly putting downward pressure on the market, which gives brave investors a chance to make outsized returns.

Brave or Foolish?
Before you puff up your chest and stride confidently into the equity markets, let's look at the facts Altucher puts forth:

1. Earnings are "blowing away" analyst expectations.
2. Unemployment isn't as bad as everyone thinks.
3. The economy is growing (here, and in China).

I'll start with earnings, because they tie closely into the other two. First off, earnings are backward-looking, so whether or not priceline.com (Nasdaq: PCLN) was able to fight off a volcano and slumping consumers in both the U.S. and Europe, and post better-than-expected results last quarter, doesn't really matter for someone looking to invest now. The real question is: Where are things going?

While Priceline expects to see continued strong growth in the third quarter, this isn't true for everyone. According to data from Standard & Poor's, of the 93 companies in the S&P 500 that have offered guidance for the third quarter, 58 are expecting weaker performance, and just 24 are expecting to see improving conditions. That's a nearly 2.5-to-1 ratio of gloom, and it's significantly more negative than what we saw going into the second quarter.

Why so glum?
To help explain this overcast outlook, let's look at what drives earnings. At the most basic level, selling stuff to people fuels the bottom line. Here in the U.S., consumers contribute nearly 70% of GDP, which means a lot of selling. However, if Americans are unemployed, they aren't able to buy as much, so unemployment numbers become important for looking at future earnings.

Now, Altucher thinks things aren't so bad on the employment front, pointing to 200,000 private-sector jobs being created each month. I'm not sure where he gets this number, since the Bureau of Labor Services reports that we have created only 150,000 new private sector jobs -- in the last three months. This data discrepancy aside, normal growth in the labor force dictates that we need to create 120,000 jobs a month just to stand still on unemployment. So even if we're achieving 200,000 a month, unemployment won't be declining all that rapidly. These numbers don't strike me as all that encouraging for future revenue growth.

The bigger picture
As far as the economy growing, Altucher is correct in asserting that 2.4% GDP growth is better than zero. However, a look at quarterly GDP growth trends isn't exactly inspiring:

Source: Bureau of Economic Analysis.

Now, consider the fact that purchases of software and equipment and a tax incentive-driven bump in home buying were two major contributors to GDP growth in the past quarter. Businesses buying new, faster computers may have helped Intel (Nasdaq: INTC) and EMC Corporation (NYSE: EMC) register the best quarter in their histories, but it doesn't really lead to more jobs (you could argue that investment in improving productivity reduces employment in the short term), and artificially created demand isn't sustainable.

In fact, I'd argue that the success we're seeing from companies like Intel and Priceline should cause concern about the U.S. economy. When companies are worried about slowing sales growth, they focus on cost-cutting measures. While spending on things like computers, software, and equipment may seem counter to this, improving productivity actually helps the bottom line. Remember, employee salaries are the largest expense for a company, and if you can do more with fewer of them, a CFO will almost always make that move.

Additionally, Priceline is predicated on providing consumers with the lowest prices for their travel needs. The company is not only benefitting from a growing global footprint, and from consumers' increasing confidence in online shopping, but also from U.S. consumers' desire to save money while still living the life to which they have become accustomed.

The fact that Expedia (Nasdaq: EXPE), one of Priceline's major competitors, also posted better-than-expected earnings tells me we are seeing a shift in consumption trends (a tide lifting all boats, if you will), and not necessarily just outstanding performance by an industry leader.

So what?
All of this leads me to believe that we could be in for some bumpy markets in the months and quarters ahead, with most of the uncertainty to the downside. This isn't to say you can't find stocks that will outperform, but you will have to be selective. Stocks, in general, don't appear to be that cheap to me, given the economic headwinds we're facing.

The key to successful investing will be finding the companies, like Priceline and Intel, which are positioned to benefit from the economic environment we are in, or are changing the way an industry does business. Easier said than done.