Lower P/Es now may mean... lower P/Es in the future

MARKET MOVER

Are Low P/Es A Valid Reason To Buy Stocks?

With Earnings Shaky And Inflation Climbing, More Declines Possible

By TOM LAURICELLA
March 10, 2008

(WSJ) With the economy showing clear signs of recession and the credit markets in turmoil, the floor under stock prices seems to be getting thinner. Here is another reason to worry: Stock prices aren't as cheap as they seem, and based on other periods when inflation was accelerating and the economy weak, the market can struggle for prolonged periods.

Some argue stocks are attractively priced after a 17% decline in the Standard & Poor's 500-stock index since October. Based on earnings forecasts for 2008 collected by Reuters Estimates, the S&P 500 is trading at 13.2 times projected earnings, compared with an average of 16.5 times going back to 1989, according to data compiled by Morgan Stanley.

Price-to-earnings ratios reflect the amount investors are willing to pay for future earnings. When these ratios fall below long-term trends, conventional wisdom is that stocks are cheap and it is time to buy.

Until 2000, investors feasted on the combination of rising P/E ratios and rising stock prices. At the end of the 1980-82 bear market, S&P stocks changed hands at a price-to-earnings ratio of 8.7, according to Morgan Stanley's data. In the next 17 years, the ratio moved higher, topping out just shy of 30 in the spring of 1999. During that time, when the S&P rose an average of about 17% a year, roughly one-third of returns on the S&P 500 were the result of rising P/E multiples, according to Ibbotson Associates.

That period also featured a long downtrend in inflation and interest rates, which generally lead directly to higher multiples. Now, inflation is quickening, and interest rates, while heading down, can't fall much further. This suggests an environment less conducive to rising stock multiples.

That was the case in the most recent bull market, when price-to-earnings multiples actually fell even as the market rose. When the bull market began in early October 2002, the S&P 500 had finished the previous month at a P/E ratio of 17.6 when measured against the previous 12 months earnings. This past September, just before the market began its descent, the ratio was 16.8.

It is a similar story when looking at expected earnings, the basis on which stocks currently look cheap. At the end of September 2002, the S&P 500 was priced at 14.5 times the coming 12 months expected earnings, according to Morgan Stanley. This past September, after a five-year run in which the S&P 500 rose an average of more than 15% a year, the P/E on the index was 14.8 times the coming year's expected earnings.

"The growth in stock returns came mostly from earnings growth," says Peng Chen, chief investment officer at Ibbotson Associates.

Morgan Stanley analysts contend that stubborn inflation means investors won't be willing to pay big premiums for future earnings. Goldman Sachs Group strategists say that based on typical declines in P/E ratios in the past four recessions, stock multiples can go much lower.

Nicholas Bohnsack, of Strategas Research Partners, says it is a mistake for investors to assume multiples will head higher. There have been extended periods in which multiples went down or were flat, most recently in the 1970s, he notes. Today, he says, "We're in a secular period of multiple contraction," which features lots of "sideways, grinding of multiples."

Part of the problem is that the earnings side of the equation is looking shaky. Wall Street analysts predict a double-digit increase in corporate profits for 2008, but forecasts have been pared back. As of Friday, S&P 500 stocks are expected to generate $98.25 in earnings a share this year, down from the $101.87 a share predicted at the end of last year, according to Reuters.

Analysts have taken an especially sharp knife to estimates of first-quarter earnings, which now are expected at $22.58 a share, compared with the $23.64 forecast at the end of December. That means instead of rising at a 5.1% rate, first-quarter earnings are expected to be basically flat.

Another problem is inflation. In a number of recent sessions, the stock market has reacted positively to higher commodity prices on the theory that it will boost profits of energy and materials companies. But if inflation stays stubbornly high despite the U.S. economic slowdown, it would be a negative for multiples, because it reduces the value of future earnings.

Abhijit Chakrabortti, Morgan Stanley's chief global and U.S. equity strategist, says inflation is running about 0.8 percentage point above the long-term trend of 3.5%, and value for the S&P 500 should be reduced by the same amount. With that factor taken into consideration, he argues that current fair value for the index is about 17 times trailing earnings, not much above its present reading.

Ed Easterling, president of Crestmont Research, argues that record increases in earnings and profit margins in recent years make prices look artificially cheap. He prefers to look at the 10-year trends in earnings, from which he removes the impact of inflation and smooths out the short-term ups and downs in profit margins. That, he contends, provides a cleaner picture of stock valuations.