Stock Prices Drop Back to Basics

THE stock market came close to ``the riot point'' last week. That's how Warren Smith, editor of the Montreal-based Bank Credit Analyst described the plunge in United States stock prices. Sell orders were so prevalent Thursday that the New York Stock Exchange was unable to open trading on time in some popular stocks. Stock market ``circuit breakers'' - trading rules to prevent price declines from turning into uncontrolled panic - were imposed. But prices kept heading south.

Mr. Smith says investors - individual and institutional - are ``getting out of control.'' On Friday, stocks enjoyed what analysts were calling a ``technical rally.'' But for the week, the Dow Jones industrial average had sunk 111.88 points to 2,532.92. Other world markets were down as well.

What has happened, according to Smith and some other analysts, is that stock prices rose well beyond their ``fundamental worth'' this spring and summer. The Dow peaked at just over 3,020 in mid-July. Then the slowness of the economy became clearer. And Iraqi President Saddam Hussein ordered his troops into Kuwait, sending the price of oil soaring. Economists marked down their forecasts further, some seeing a recession ahead. Stock analysts began to suspect their earnings predictions for various corporations would be too optimistic.

``We could have further to go to get down to a reasonable price,'' says H. Bradlee Perry, chairman of David L. Babson & Co., an investment counseling firm in Cambridge, Mass.

Bank Credit Analyst (BCA), a Canadian research group whose reports are widely followed in the US as well as Canada, points out that a major recession has followed every big rise in the inflation-adjusted price of oil in this century.

``The most liquid source of money to pay for the additional oil bill will come from the world stock and bond markets,'' states a BCA publication. ``Every dollar-a-barrel increase in the price of crude raises the global oil bill by roughly $25 billion; a $10 hike would push [extra costs] to $250 billion, which represents 2.5 percent of world stock market capitalization.''

Actually, oil prices have risen some $13 from what Smith calls their former ``equilibrium price'' of $18 a barrel. If that holds, the cost to oil consumers will be $325 billion. It is no wonder stock markets around the world have been hard hit.

SMITH expects the Group of Seven industrial countries to try to stem the fear at some point with a joint statement. The finance ministers of these countries - the US, Japan, Britain, France, West Germany, Italy, and Canada - might promise to lower interest rates together, pumping liquidity into the international financial system, speculates Smith.

Except for the Iraq oil shock, both Smith and Perry figure that share prices at the moment are not far out of line with ``fair value.'' The price to earnings ratio (P/E ratio) of broad stock averages, using earnings for the past 12 months, is about 13. The long-term average P/E ratio is about 13.5.

``Prices are reasonable, but not cheap,'' says Perry.

But the rise in oil prices, if it brings an economic slowdown, could knock down earnings further. The P/E ratio got under 9 in 1982 when there was a ``negative market psychology,'' Perry says. Much depends on what happens in the Middle East - a long siege of Iraq, a shooting war, or a quick negotiated settlement.

Perry's advice is that those investors holding cash be patient before getting back into the market. There's no hurry, he says.

As for those holding quality stocks, don't bail out now, Perry suggests. He recalls that when OPEC quadrupled oil prices in the fall of 1973, the market averages fell almost 50 percent by August 1974. But they were nearly back to their old peak a year-and a-half later.

Over the long run - since 1926 - the average total return on stocks (price appreciation plus dividends, untaxed) has been 10 percent a year. That's better than bonds. Investors rushing into gold, oil, and Treasury bills are in danger of ``throwing out the baby with the bath water,'' Smith says.