ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Follow us on

Exclusive Sponsorships

Most Popular This Month

Most Popular This Year

P/E: Future on the Horizon

May 3, 2011

by Ed Easterling

P/E multiple

The price-to-earnings ratio ("P/E") is the major multiplier of stock market returns over time. Sometimes, however, the multiplication is a fraction rather than a whole number. When P/E rises over time, the increase in the multiple exponentially drives returns. This creates periods of above-average returns — the secular bull markets. Conversely, a decline in P/E over time offsets earnings growth and leads to periods of below-average returns — the secular bear markets. P/E, therefore, is a major factor for the ultimate course of the stock market.

P/E does not follow a random course; it is driven by the trend and level of the inflation rate. Chart 4 reflects the relationship of P/E and inflation. Periods of higher inflation or deflation drive P/E lower and periods of price stability (i.e., low and stable inflation) drive P/E higher.

[dshort note: for more details, see P/E: So Many Choices, Part II posted on April 27.]

Y Curve Effect

This is important because it provides the framework to understand that P/E is not a random variable, but rather one that is subject to fundamental forces and principles. The change in P/E over time is not only one of the three components of stock market returns (dividends and earnings growth are the other two), it has the most significant effect on the variability of returns over decade-long periods.

P/E is not only driven by inflation, it is also driven by the long-term growth rate of earnings. Earnings growth over the long-term is driven by economic growth. Historically, real economic growth has been relatively constant across the decades averaging near 3%. As a result, P/E progressed from highs to lows based upon the inflation rate.

The range of highs and lows, from just over 20 to just under 10, was determined by the 3% economic growth constant. Had economic growth been lower, then the range and average P/E would have been lower. This paragraph cannot be emphasized enough — the implication is a game changer for P/E if the long-term future reflects lower economic growth.

The 2000s brought a period of economic surprise. The growth rate was not 3%. Conventional wisdom, based upon excessive leverage and unsurpassed American consumerism, holds that economic growth surged forward unsustainably. Supposedly, the U.S. is now expected to atone for that binge with a decade or more of slower growth.

But, real GDP growth in the 2000s was only 1.8%. Even before the 2008 recession, cumulative GDP was chugging along at 2.6% annually and did not exceed 2.7% annually during that decade. Therefore, and this is a major unknown, the economy may be positioned for a restorative above-average decade ... or it could have downshifted to a new lower level. This emphasizes why future economic growth is Major Uncertainty #1 in Probable Outcomes.

A 4% decade would simply get the economy back on track for its 3% trek. If the new economy provides only 2% growth, however, the impact is a downshift in the range for P/E. Note in Chart 5 that the inflation rate will continue to determine the position within the range, but the growth rate determines the level of lows and highs.

Chart 5. P/E Drivers: The Inflation Rate & The Growth Rate
Growth Compression