Corporate Profits Have Stalled. Has the Market? WHILE the stock market was soaring during the last two quarters, a big worry was hanging over it: corporate earnings growth was slowing. Still, bullish investors could take comfort that stocks were cheap by most standards. When it comes to predicting the market's direction, however, it may not matter if equities are undervalued or overvalued. Historically, strategists note, high price-to-earnings ratios don't prompt sell-offs themselves. The real issue, they argue, is whether the market's P/E ratio has room to grow. And that remains a big question. P/E ratios, which are used to gauge market sentiment and valuations, rise or fall based both on earnings and the price that investors are willing to pay for each dollar of that profit. When optimism about the markets and the economy's health started to take off late last year, the P/E of the Standard & Poor's 500 index, based on projected profits over the following 12 months, jumped from about 10 to more than 13 in less than six months. The problem is that earnings growth has ground almost to a halt - profits for companies in the S.& P. 500 are expected to grow just 1 percent in the first quarter and 2 percent in the second. That means that the only real hope for additional stock market gains this year is expansion in the P/E ratio, which may be bumping up against a ceiling. "We already got a year's worth of returns in just three months," says Mark D. Luschini, chief investment strategist at Janney Montgomery Scott, referring to the first-quarter gain of 13 percent in the S.& P. 500. That would suggest we borrowed a bit from the future. And that, in turn, would imply that price-to-earnings ratios are more likely to fall than rise. They've already started to do just that. Since the market began to pull back early this month, the index's P/E, based on projected earnings, has fallen to around 12.5, from 13.1. Lingering fears in the global economy may also weigh down P/E's, says Jason Hsu, chief investment officer for the investment consulting firm Research Affiliates. Last week, for instance, a sudden jump in Spain's bond yields renewed concern that the worst of Europe's debt crisis may not be over. Yet there may be another reason that P/E ratios won't grow, Mr. Hsu says. The price that investors are willing to pay for earnings tends to jump most in the very early stages of an economic recovery, when optimism is teeming and growth is robust, he explains - but the current bull market is already three years old. Indeed, in the last 70 years, the price-to-earnings ratio of the S.& P. 500, based on reported earnings, has typically surged more than 30 percent in a bull market's first year - and peaked in that first year, according to an analysis by Sam Stovall, chief equity strategist at S.& P. Capital IQ. Doug Ramsey, chief investment officer at the Leuthold Group, prefers to analyze P/E ratios by using actual average profits over the last five years, thus smoothing out extreme highs and lows in the cycle. By that measure, the P/E of the index recently climbed as high as 20.4, slightly higher than the historical median ratio at bull-market peaks dating back to 1876. That doesn't necessarily mean, however, that this bull has run its course. Mr. Ramsey notes that there have been plenty of cases when the market has soared above a P/E of 20. In 1998, for example, the five-year average P/E of the S.& P. 500 stood at 27.7. Historically, he adds, individual investors have a knack for stepping into the market when the ratio is already elevated, as they often wait until stocks are high before buying. If stock mutual funds experience an influx of new money from retail investors - which he says could be likely in light of improvements in the employment outlook - modest market gains could be achieved this year. Finally, don't count out profits just yet, says Jack A. Ablin, chief investment officer at Harris Private Bank. Though earnings for companies in the S.& P. 500 are expected to be largely flat in the first half this year, analysts predict a modest rebound in the second half. According to S.& P. Capital IQ, which tracks earnings estimates for S.& P. 500 companies, the consensus on Wall Street is that corporate profits will rise 5.9 percent in the third quarter and 16.3 percent in the fourth quarter, compared with the year-earlier periods. For the full year, that means earnings could grow by a modest 6.4 percent. While that's a far cry from the 16 percent growth rate in 2011, Mr. Ablin says that "it's too early in the earnings season to quit and sit out the market."