Secrets Of Success: Keep fall in p-e ratios in proportion

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The Independent Online

A few weeks ago I commented on the view held by Peter Bernstein, the New York market-watcher, that investors need to have a long-term perspective on the relationship between bond and equity returns, discounting the historical anomaly of the high inflation years of the 1970s and early 1980s when making comparisons.

This week I have been looking at some other aspects of the long-term relationship, including the very topical question of how inflation impacts on price-earnings ratios and market valuations.

One of the interesting features of the last few years has been that despite the recovery of the stock market since the end of the bear market in 2003, price-earnings ratios have continued to decline.

In other words, investors collectively have continued to place a relatively lower value on each pound of earnings than they did before. In fact, since the peak of the bull market in the year 2000, when shares were admittedly on dottily high valuations, the average p-e ratio of the London market has virtually halved.

If you look behind the figures, the explanation that emerges is that company profits have been rising very strongly - they are now at near record levels as a percentage of GDP - but investors have become less inclined to value those earnings so highly. At the peak they were prepared to pay 300p for a company with 10p of earnings, now the figure is 150p or less.

On the face of it, this seems odd: after all, rising profits ought to be good for stock market investors. Nothing, however, is ever quite so simple in investment. Two factors in particular are relevant here. One is that there is good reason to believe that company earnings are what economists call a mean-reverting series - that is to say, they will over time return to their longer term average levels.

The reason is simple: reversion to the mean is how capitalism is meant to work. In a free market, high and rising profits will inevitably attract competition over time and those companies that earn exceptional profits cannot expect to sustain them forever, unless they can find ways of eliminating that competitive threat. (The secret of Warren Buffett's success is that he tries to invest only in those companies that have what he calls "wide moats" around their core business).

So, if investors are being rational, they should place a lower earnings multiple on companies that are at the peak of their profitability cycle. All valuation methods are by definition forward-looking, and simply extrapolating present earnings into the future indefinitely is a recipe for disappointment. A particular concern now is that the corporate sector has been hoarding cash rather than investing for the future.

The second relevant factor is that market valuations are not set in a vacuum. The price investors are prepared to pay for a pound of company earnings is influenced quite heavily by the relative attractiveness of competing investment assets.

Interest rates are an important factor here. Their effect is to increase the yields on bonds and other competing asset classes, and to increase the rate at which future earnings need to be discounted to arrive at their present value (quite apart from their immediate effect in reducing the profits of companies with high levels of debt).

Putting these two factors together, therefore, there is nothing particularly strange about the present phenomenon of contracting price-earnings ratios. An environment of rising interest rates and unusually high rates of profitability is a perfectly plausible background against which to expect the price investors are prepared to pay for every pound of company earnings to come down. Those who base their case for adding to their holdings of shares at the present time simply on the fact that p-e ratios are low by recent standards are being over-simplistic.

That said, there are still some other odd features about the present market. The recent market weakness has been widely blamed on fears of resurgent inflation in the US economy, which in turn has led to expectations that the Federal Reserve will have to raise interest rates even further than most market participants have been expecting. The knee-jerk reaction of markets over the years is always to push share prices lower when the spectre of in- flation re-emerges.

As Tim Bond, the head of asset allocation at Barclays Capital, pointed out this week, the correlation between earnings yields and inflation is very high, but not necessarily very rational. In other words, when inflation rises, price-earnings ratios (which are simply the inverse of the earnings yield) tend to fall, and vice versa. As the chart shows, this pattern has held very closely from the 1960s onwards (though remember that this is precisely the period that, if we believe Bernstein, we now need to discount as an historical anomaly).

One final anomaly about price-earnings ratios worth noting is that the traditional differential in valuations between high quality and low quality companies has virtually disappeared in the past few years. This has a lot to do with the distortions created by the cheap money policy of the Federal Reserve in the post-2000 period, something that Ben Bernanke, its new chairman, is now struggling to correct. It is reflected in the wave of M&A activity that is continuing at high levels this year.

Putting this altogether, it leads me to think that the much-vaunted period when large cap growth stocks start to outperform the rest of the market once more will indeed arrive quite soon. The broader question is whether or not the present perceived inflationary threat becomes a reality or is successfully headed off by policy responses. That is too early to call, but a lot of things - including the future course of p-e ratios - will be riding on the outcome.

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