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Well done, and a heckuva study.
One really important issue: WHY did the PE inflation of the 90's occur ?
Answer: Greed
WHY will PE deflation of the 02+'s occur ?
Answer: Fear
What controls greed and fear ?
Answer: the flow of money
Where's all of the money flowing right now ?
Answer: to the government
(see today's job report details.....all new jobs are in the government or
government-related contractors.....the private sector is dead)
Conclusion: Until the government REFLATES in a massive way, this market's
going down or nowhere.
> -----Original Message-----
> From: Gary Funck [mailto:gary@xxxxxxxxxxxx]
> Sent: Thursday, September 05, 2002 9:42 PM
> To: Realtraders@xxxxxxxxxxxx Com
> Subject: [RT] P/E inflation and the tenuous relationship between E and P
>
>
>
>
> I ran the following what-if study. Perhaps some folks here will find it of
> interest.
> The idea behind the study was to first look at the relationship
> between changes
> in
> stock prices and changes in earnings, and the second part of the
> study projects
> the price of the S&P forward, and demonstrates how dramatically
> the price might
> fall, even though earnings are improving at a normal pace, yet
> the P/E premium
> recedes from its current high level down to a level more typical
> of bear market
> and recessionary periods.
>
>
> I began with the S&P earnings data (and forecasts) on this page:
> http://www.spglobal.com/earnings.html
>
> The first thing that I looked at was the relationship between as-reported
> earnings changes (the earnings that including acquisition charges ans
> amortization) and S&P price changes. See the attached chart,
> which shows the
> quarterly percent changes for the S&P and S&P earnings, annualized.
>
> Over the 1988 through June 2002 timeframe (14 years), the average
> annualized
> S&P percent change was 11.4% with a 16% standard deviation. The average
> annualized EPS change was 6.4% with a 28% standard deviation. The
> first simple
> conclusion we can reach is that something like 5% of the excess
> return in the
> S&P was due to "P/E inflation" over the 1988 through 2002 period.
> Interestingly, when we eyeball the chart, it is difficult find a
> relationship
> between S&P price changes and S&P earnings changes. In fact, a linear
> regression of s&P price change as a function of EPS change gave
> an R-squared of
> close to zero, confirming that S&P price changes appear unrelated to EPS
> earnings changes during this period.
>
> I also looked at the lead/lag relationship between S&P price
> changes and EPS
> changes:
>
> Lag Correlation
> 0 0.21
> 1 0.21
> 2 0.13
> 3 -0.03
> 4 -0.11
> 5 -0.23
> 6 -0.35
>
> Above, "Lag" is the number of quarters that EPS is lagged in the
> correlation
> calculation. The convential wisdom is that S&P price changes lead
> EPS price
> changes by 2 to 3 quarters (6 to 9 months). The correlation study
> above shows
> that 0 and 1 quarter EPS lags (or S&P leads) had the highest
> correlations, but
> the level of correlation was rather low. Lags of greater than 2
> quarters shown
> an inverse relationship.
>
> I then tried to forecast the S&P forward 3 years, by beginning with the
> analysts
> rather optimistic EPS forecasts for the next 5 quarters, and then
> assumed an
> average annualized EPS gain of 6.4% annual growth rate after that
> (which is in
> line with the average over the past 14 years). Some might argue that S&P
> forecasts are unrealistic, and that the economic environment may
> not support an
> EPS growth rate of 6.4% -- I'll simply argue that this scenario
> is at least
> somewhat optimistic in the current economic climate. To complete the
> forecast, I assumed that the trailing twelve month P/E of 28.2
> drops over the
> course of the next three years to a rather low level of 10.7
> which was last
> seen in 1988. Thus, the forecast assumes that earnings growth is
> robust and at
> least as strong as that seen in the last decade, combined with a
> decline in
> P/E. As an aside the recipricol of 6.2% would yield roughly a P/E of 15.6,
> which is consistent with the longer term S&P average (as reported) P/E of
> 17/so. Thus, the P/E inflation of the past 1990's doesn't seem to
> be justified
> by the actual EPS growth rates.
>
> Given the forecast's assumptions, the S&P would decline further
> to about the
> 545 level in Q3 of 2005. In this scenario, given reasonable
> expectations for a
> risk premium on the stock market, the S&P should be trading at about a 477
> level in order to be a value-based buy at this time.
>
>
> To summarize:
> 1) The connection between S&P price changes and EPS changes during the
> 1988-Q2.2002 time frame seems tenuous at best.
> 2) The P/E inflation seen during the 90's (and especially the
> late 90's) seems
> unjustified, based upon actual EPS growth rates.
> 3) The combined assumptions of average to high EPS growth rates
> and a declining
> P/E benchmark leads to the conclusion that the S&P can drop a lot
> further over
> the course of the next three years.
> 4) For the S&P to trade higher from here, either the EPS growth
> rate will need
> to be much higher than normal, or the market will have to remain
> comfortable
> with historically high P/E levels.
>
>
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>
>
>
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>
>
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