What Is the Real Rate of Earnings Growth After Inflation?

by: TradingHelpDesk

The previous article highlighted performance year to date on the S&P 500. Some stocks have had a great run, but the market is now suffering profit-taking. Did the market move too far too quickly or is the current retreat just a pause before the next-step up? To answer that question it helps to look at forward looking valuations. Again, green is good and indicates a relatively low forward looking price to earnings ratio. Red indicates a higher p/e ratio. Of course we need to consider the possibility that nominal earnings will not grow as quickly as they usually do into an economic recovery, but the enormous stimulus and monetary easing we have seen internationally implies nominal earnings can and will grow into 2010 and beyond.

Actually I don’t think the question is; will earnings grow at or above the historical average growth rate in nominal terms? I am sure they will. But if inflation rises as quickly as it should considering the trillions of dollars of stimulus, the question should be; what is the real rate of earnings growth after inflation is taken into consideration? Post inflation, the prospect of historically average earnings appreciation is less attractive for investors seeking real, not nominal, portfolio appreciation, especially when you factor in the requisite risk premium for holding equities relative to more secure assets.

The scenario bodes well for investors who find a government or institution desperate enough to offer a coupon above inflation, via an index linked instrument. Now that asset would be a beautiful shade of green in my eyes, particularly if I can invest at par and hold for the duration. But beauty is in the eye of the beholder and a great nominal return, even one eroded in real terms by inflation, will be enough for some. Particularly the hedge funds that need to re-capture the high water mark on their absolute return funds before they can claim those 20% performance related fees again.

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Heatmap Source: www.finviz.com