Tuesday, September 20, 2011

S&P 500 Valuation

Previously, on several occasions, I argued that the stock market’s valuation multiple may have more to do with the perception of America’s leadership in the world and the leadership of America. Most recently, in the August 4 Morning Briefing, I noted the similarities between the disappointing leadership provided by Jimmy Carter and Barack Obama, though they both won the Nobel Peace Prize. At 11.3, today’s forward P/E is still above the 6-8 range during the Carter years. But it did drop sharply in recent months along with Mr. Obama’s popularity.

What about interest rates and inflation rates? They soared during the Jimmy Carter years. Now both are extremely low, but that doesn’t mean that they are necessarily bullish for valuation. Today’s two charts compare the S&P 500’s forward P/E to the expectations component of the Consumer Sentiment Index (CSI) and the expected inflation rate in the 10-year TIPS market since 2007. Here are some obvious observations:

(1) The CSI’s expectations component fell to 47.0, the lowest level since March 1980 during the first two weeks of September. Guess who was president back then? During August, the forward P/E was 11.4, the lowest since February 2009. It isn’t much higher than the previous cyclical low of 10.4 during October 2008. Gallup reports: “Americans’ current level of economic confidence--which represents their views on the current state and future direction of the nation’s economy--is decidedly negative. Seventy-seven percent said the economy was getting worse in August, the highest--by far--since February 2009, the month in which Congress passed a $787 billion stimulus bill in hopes of lifting the U.S. economy out the depths of the recession.”

(2) During the 1980s and 1990s, falling inflation and interest rates were bullish for valuation. However, those rates were much higher than they are now. Today, these rates are much closer to zero, and falling inflation and interest rates raise the specter of a deflationary depression, which would be a very bearish scenario. That explains why there has been a very close fit between expected inflation in the 10-year TIPs and the forward P/E. The former fell from a 2011 high of 2.62% during the week of April 15 to 1.94% last week. Over this same period, the P/E dropped from 12.8 to 11.0.

No comments: