- Expectation economy will continue to growth over next 12-15 months at annual 2-2.5% rate, which he considers the ideal rate to deliver corporate growth with moderate inflation so the Fed does not need to intervene. He believed that capital investment in energy and growth from foreign demand would make up for the housing downturn (housing would take 1% off gdp growth).
- Inflation will continue to be moderate, as economy slows. Evidence is that inflation expectations built into fixed-income prices have been receding in prior six months and are at 12-month lows.
- Corporate profits will continue to grow. 5 months into economic expansion period, 72% of companes are reporting positive earnings surprises. He expected next year earnings would slow to the 7-9% range. Moreover, ROE and margins are close to record levels, balance sheet leverage is down and dividends are growing 10-12% and share buybacks are near a peak.
Cooperman also sites the same relationship between inflation and P/E ratio as Lim does: "when the rate of inflation has been between 1-3%, historically the S&P 500 multiple on forward earnings has averaged over 17x. Inflation is now in that range, but the current S&P multiple is around 15x." This relationship is (according to the NYTimes) from Charles Schwab, based on data from Jan 1960 to March 2007, although the Schwab data is based on trailing rather than forward earnings. Table follows: (don't know why there's blank space below)
| Inflation Rate | Average P/E Ratio |
| >7% | 8.5 |
| 6-7 | 9.5 |
| 5-6 | 13.1 |
| 4-5 | 14.8 |
| 3-4 | 17.6 |
| 2-3 | 19.7 |
| <2 | 23.6 |
Inflation measured based on yoy changes in personal consumption expenditures, excluding food and energy. P/E ratios are for stocks in S&P 500 index, using trailing 12-month GAAP earnings.
May 20, 2007
FUNDAMENTALLY; The Bull Market That's Missing Something
NY Times ;By PAUL J. LIM
SO far, this bull market has benefited from several tailwinds, including the resilient economy, reasonably low interest rates, better-than-expected corporate profits and, most recently, a flurry of merger-and-acquisition activity. But one missing ingredient has been the willingness of investors to pay higher prices for earnings.
''So far, it's been an untapped driver of returns,'' said Jeffrey N. Kleintop, chief market strategist at LPL Financial Services in Boston.
In every bull market since 1942, investors gradually gave higher price-to-earnings ratios to stocks as those rallies unfolded. Indeed, the average P/E ratio for the S.& P. 500 has typically grown from 13.5 at the start of new bull markets to 17.3 by their fourth birthdays.
But the same can't be said for this rally -- at least not yet.
The current bull, which was born on Oct. 10, 2002, started with a P/E ratio of 27.1, according to S.& P. Four years later, the ratio was actually much lower, at 16.3. (All of these figures are based on trailing 12-month earnings, using generally accepted accounting principles, or GAAP.)
Why are investors stingier with their investment dollars this time around?
Part of the explanation may simply be the hangover from the bear market of 2000 to 2002, said Tobias M. Levkovich, chief United States equity strategist at Citigroup Investment Research. He argues that investors may be hesitant to push P/E ratios higher after getting burned so badly for doing so at the start of the decade.
The lack of a P/E expansion could also be tied to the surprising strength in corporate earnings growth. At the start of April, the consensus forecast for first-quarter S.& P. 500 earnings growth was a modest 3.7 percent. But now, it looks as if first-quarter profits will jump 8.1 percent when all is said and done, according to Thomson Financial.
And when the ''E'' -- the earnings -- in the P/E ratio grows at a faster-than-expected rate, it's not so surprising when the ''P'' doesn't keep pace.
Of course, ''as earnings slow from here, the markets will need an extra boost,'' Mr. Kleintop said. And there are some early indications that investors may be willing to pay slightly higher prices for stocks in coming months.
Sam Stovall, S.& P.'s chief market strategist, noted that at the end of March, the P/E ratio of the S.& P. 500 was 16.8 (again, based on trailing 12-month GAAP earnings). The multiple grew to more than 17 by mid-May. And if the S.& P. 500 breaks its all-time high of 1,527.46 within the next few days, the market's P/E will rise to around 18.
Yet this is only a short-term move. And few are expecting the type of P/E expansion that the market enjoyed in the mid-1980s and the mid-1990s.
From 1984 to 1986, for example, the P/E of the S.& P. grew to about 14 from around 8. The move was even bigger from 1996 to 1998. Investors started that period paying 14 times trailing 12-month earnings. But by the end of it, the multiple had grown to 24.
Market strategists note, however, that those periods were marked by significant declines in long-term interest rates and inflation -- both of which have an inverse relationship with market P/E ratios.
Given that 10-year Treasury notes are already yielding less than 5 percent -- and given that core consumer inflation is running about 2.3 percent, according to the Labor Department -- it's hard to imagine a huge kicker from similar trends this time around.
As a result, Jim Dunnigan, chief investment officer at PNC Wealth Management in Philadelphia, argues that while P/E ratios are likely to expand, ''it should be more muted than it was in the past.''
Mr. Kleintop agrees. Instead of a 6- to 10-point surge in P/E ratios, he says, we're more likely to see a bump-up of about 3 or 4 points. Still, based on trailing 12-month earnings of nearly $90 a share for the S.& P. 500, a climb to a P/E of 19 -- about 3 points above the level of last October -- would bring the index to a record level of about 1,700.
That, of course, is based on a lot of ifs. Whether market P/E's will climb this high in this bull market will depend on several factors, including these:
THE INFLATION OUTLOOK -- Liz Ann Sonders, the chief investment strategist at Charles Schwab, says that there is ''a perfect inverse correlation of inflation and P/E ratios.'' Since 1960, whenever the annual inflation rate (as measured by core personal consumption expenditures) has been 2 to 3 percent -- as it is today -- the average P/E for the S.& P. has been 19.7. But when inflation edges just above 3 percent, that average P/E has dropped to 17.6, close to the current number.
THE BUYOUT BINGE -- Though P/E expansion isn't likely to be aided by big drops in bond yields, the recent flurry of mergers and acquisitions could spur the market to bid stock prices higher -- at least to better reflect recent earnings growth, Mr. Dunnigan said. According to Thomson Financial, global merger-and-acquisition activity is on pace to shatter last year's record of $3.6 trillion of deals. If that holds true, there could be an uptick in P/E multiples.
THE PATH OF TECH AND HEALTH CARE STOCKS -- Historically, these stocks have had high P/E's, but both of these sectors have generally been out of favor since the start of the decade. That is one reason the P/E ratio of the S.& P. hasn't greatly expanded, Mr. Kleintop says. But now that tech and health care companies are again among the market's earnings leaders, the ratio could be driven higher.
Of course, the multiple could surge for another reason: if earnings fall off a cliff, as they did at the start of this decade. That would be about the worst type of P/E expansion imaginable, but, fortunately, few are predicting it. In fact, though earnings are slowing, the consensus is that earnings for the S.& P. will still grow 7.1 percent this year.
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com.
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