March 12, 2001: Spotlight
Abby Ignores Ominous P/E Patterns
By Brady Willett
Through out history the markets do not adhere to any strict gravitational laws. However, at times,
you could have avoided steep losses by simply staying out of most stocks when the average price-to-earnings ratio on the S&P 500 surpassed 20.
The price-to-earnings ratio (stock price divided by annualized EPS) comments on the premium investors pay for stocks. For instance, a company such as Cisco trades with a trailing P/E multiple of 59, while Philip
Morris trades at comparatively low multiple of 13 – investors are willing to pay a greater premium for Cisco because it is expected to grow earnings at a quicker clip than Philip Morris. In sum, P/E's are an intangible
investment instrument: they rise, and fall based on investor perceptions concerning growth projections, and a host of other factors.
P/E's are especially important today because they sit in contradiction to downgraded investors expectations. The S&P 500 still maintains a P/E average of over 20, and this despite the precarious earnings situation over
the next six months.
Investors have become increasingly willing to pay more for stocks now than they did back in 1996.
Furthermore, a broader look at history tells us that investors have been willing to buy the S&P 500 at or above its historical P/E average for nearly a decade.
The historical danger of escalating earnings multiples has been that earnings increases do not reflex the P/E
average back to the median. Meaning that every time the P/E ratio contracts below 16 it has been the result of a concurrent drop in equities, not because of a dramatic increase in corporate earnings. In this regard,
how can the current P/E picture ever become historically focused without a steep drop in stock prices?
Bulls Ignore P/E's
Those analysts currently making bullish claims on equities do not quantify their predictions based on
earnings. What the analysts do is provide a deterministic bull market model; biased theory grounded on the notion that investors will ultimately increase their risk premiums. For instance, when Abby Joseph Cohen
calls for 1,650 on the S&P 500 by years end, what she is really predicting is that investors will pay more for stocks, not that corporate earnings will increase and make the markets more attractive on a P/E basis.
"We now believe that many of the imbalances identified during the course of 2000, in both the economy and the financial markets, have now been largely resolved. Risk tolerance has been
replaced by risk aversion. Moderate overvaluation of the S&P 500 has been followed by notable undervaluation."
The conclusion of 'notable undervaluation' is a mystifying statement. Where is this undervaluation to be
seen when looking at earnings growth? Firstcall predicts the S&P 500 will post an earnings decline of 4.3% in first quarter this year, a decline of 2.2% in the second quarter, and a meager gain of 5.4% in the third
quarter. In this regard, Abby must envision a blockbuster fourth quarter earnings season: she expects the S&P 500 to rally 30+% by years-end! Perhaps Abby is looking at something else to justify her horns.
As stated, P/E multiples are limited in that they do not strictly sculpt the equity markets. The analysts can
point to interest rates, fluctuating consumer demand, monetary policy, and other hand selected economic reports to concoct any equity scenario they desire -- and in doing so completely disregard P/E's. However,
what careful investors should not ignore is that fact that if the expected economic rebound does not occur quickly the situation becomes increasingly dangerous -- P/E's will begin to rise once earnings turn
negative even if stock prices remain in a holding pattern.
Most bulls had justified record earnings multiples in U.S. equities because record economic growth was thought to be never ending. But now growth has slowed, equities have stalled, and most optimists would be
happy with 2-3% GDP this year. Does ordinary economic growth justify a 20+ P/E on the S&P 500?
The best-case scenario for the markets this year is that investors will continue to ignore the ominous P/E multiples. However, this becomes an increasingly difficult task unless the economy is thought to be growing
at an extraordinary rate. Who thinks the United States economy is still extraordinary? Abby does.