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[RT] P/E inflation and the tenuous relationship between E and P



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Several months ago I ran a similar post pointing out the S&P 500 
could move extremely lower based upon PE ratios being out of line and 
growth rate not compensating for the same.

This study done by Gary is much more erudite...but there are missing 
factors.

1. There is nothing to say that the powers that be who control the 
composition of S&P 500 stocks will not readjust the composition and 
delete non-performers and replace them with performers.

2. The Pshchology of the market and the Mutual Funds will not 
liquidate unless absolute necessity forces them to do so. While spot 
monthly liquidations excess vs new money has shown this to occur, it 
would need to be on a prolonged basis.

3. Retirement accounts have suffered the worse over the past 3 years 
similar to the 70s. They too are in no position to liquidate.Most 
journals including the AARP point out that the majority are cutting 
back consumption or taking on PT jobs. I checked The American Funds 
during the 70s and even then one could withdraw 5% per year from 
principle during the worst years and still have almost doubled their 
money after the completion of a 10 year period. 

My observation is that investors who never followed Graham/Dodd 
analysis will just hang in until market prices recover. What I see is 
the short term commodity trading mentality at odds with the long term 
investor mentality.

My commodity trading is unlike my investment philosophy...as I think 
it should be.

I am not prognosticating but I still believe that the American Stock 
Market will continue to increase an average annual minimum of 6% per 
year over time. This would lead to a doubling of the Dow every 12 
years. There may be flat years. There may be losing years. But there 
will also be outstanding years.

I would not let pure logic predict the market. If that were the case 
there would be a lot more millionaires via the market.

I posted a chart showing that over the last 3 months of the year for 
the last 10 years that the market has risen. Dow 10,000 to 12,000 is 
just as possible as Dow 6000 or lower by year end. If it is 6000, do 
you buy or sell at a bottom? If it is 10,000 to 12,000, do you keep a 
pat hand or liquidate and go to cash, bonds and/or long term CDs?

Just rhetorical questions.

John




------------------ Reply Separator --------------------
Originally From: "Gary Funck" <gary@xxxxxxxxxxxx>
Subject: [RT] P/E inflation and the tenuous relationship between E 
and P
Date: 09/05/2002 06:41pm




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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