Tuesday, June 9, 2015

Trailing P/E Is On the High Side (excerpt)

As I noted recently, valuation, like beauty, is in the eye of the beholder. I think P/Es are high. Others disagree and say they can go higher given historically low inflation and interest rates.

I counter that low inflation rates are contributing to low revenues growth. Given record-high profit margins, total earnings aren’t likely to rise faster than total revenues. Low interest rates are offset by low earnings growth, in my opinion. I’ve constructed a quarterly P/E measure based on S&P 500 reported earnings from Q1-1960 through Q3-1988 and operating earnings since then when it first became available. Consider the following:

(1) Reversion to the mean. The average of this combined series is 16.2. The P/E was 18.5 during Q1, exceeding the average by 2.3 percentage points. Historically, readings of 20.0 or more have proved to be high and often followed by bear markets.

(2) Inflation and interest rates. There is a stronger inverse correlation between the CPI inflation rate and the P/E than between the 10-year Treasury bond yield and the PE. Arguably, they both justify still higher P/Es.

(3) Earnings growth. However, there is also a very good correlation between analysts’ consensus expected long-term earnings growth over the next five years for the S&P 500 and the P/E. The former suggests that the latter may be too high.

(4) Valuation and beauty. I come to the same conclusion as before: Valuation, like beauty, is in the eye of the beholder.

Today's Morning Briefing: Which Way Is the Wind Blowing? (1) Jefferson, Einstein, and Twain. (2) The weather will change. (3) Neither boom nor bust. (4) OECD paints a picture with some shades of grey. (5) China’s trade data confirm domestic weakness. (6) Eurozone on recovery road, as Greece can gets kicked down the road. (7) Japan isn’t getting much bang for all those yen. (8) Waiting for Thursday’s retail sales report. (9) Real exports are really OK. (10) Dead calm for US stocks. (11) Revenues growth outlook is neither hot nor cold. (12) Valuation vs. reversion to the mean, inflation and interest rates, and earnings growth. (More for subscribers.)

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