Stock Valuations On the Rise

Recent gains in equity markets along with weak earnings have caused the S&P 500's P/E ratio to break to new highs. Even though the index is still well below its highs from last October, the S&P 500's trailing 12-month P/E has recently moved to a six-month high of 20.76.

During the bull market rally from 2002 to 2007, investors were waiting for the P/E expansion that usually accompanies stock prices moving up faster than earnings. Unfortunately, this time we're getting P/E expansion due to falling earnings.

The rise in the S&P 500's P/E ratio is largely a result of the extremely weak earnings in the Financial sector. As shown below, its P/E is now all the way up to 19.07, which is much higher than normal levels. The P/E ratio for Industrials, on the other hand, has not broken to new highs, even though the sector has recently made a nice move to the upside.

Comments

[linear algebra:]

This is a point with very interesting implications. I have been waiting to see something about the odd direction of multiples, since generally p/e's contract, rather than expand, in recessions. What's happening strongly suggests that there may be a second leg down in the bear market, driven by such a contraction, if it comes. If so, there are a couple of different reasons that will be used to explain such a contraction.
Also, the contrast with the performance (in terms of multiples) of emerging markets equities is something to think about. In terms of index levels, emerging markets equities have declined even more sharply than the S&P 500, and all the decline has been in multiple contraction--the only offset has been slight, and attributable to earnings growth. Maybe that's increased risk aversion, and will be enduring. Perhaps it's simply price correlation across the asset classes, and there will be a bit of whiplash and divergence if there's a second leg down in the developed world markets.

2008 Apr 02 06:46 PM

[zenalgorithm:]

This market is destined for a 30% decline from October's highs. But first we'll have a short squeeze rally to the 200 day MA.

2008 Apr 02 07:18 PM

[ItsJustMe:]

I wasn't aware of this development until today when I read a CNBC blurb where Cramer mentioned that the last time PE's got this high, the Dow crashed 1500 points and he advised his listeners to cash in their gains and get out of the market.

It doesn't surprise me however. When you watch a company take a $19 billion loss and its stock skyrockets, you begin to wonder about people's embrace of reality.

Yes, investors are more concerned with PE's going forward than they are current PE's, but anyone who thinks the financials are going to have future earnings that will support a 19.07 PE ratio are in for a rude (and very costly) awakening.

Not only have the banks taken billions in losses already, but they have billions in losses yet to come with the country slipping into recession and even after the recession, their VERY profitable days of no-money-down and "liar loans" are over.

I hate to agree with Cramer, but...looking at those PE ratios tells me that when investors wake up, it's going to get ugly...

2008 Apr 02 07:31 PM

[NARSpin:]

And that's *WITH* cooking the books and "earnings" (cough) like LEH had.
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Generally, "forward earnings are based on optimistic assumptions aböut earnings growth." (WSJ, today) "...If earnings fall 17.5%-as they have, on average, during the past three years that included recessions, then the forward P/E ratio rises to 20, undermining the idea that stocks are cheap. ...the market does not even seem to have priced in much of an earnings slowdown yet."


www.marketwatch.com/ne...

2008 Apr 02 07:36 PM

[sf123:]

interesting
the interest rate has been going down also which may support a higher PE in the market.

2008 Apr 02 08:09 PM

[WhiplashII:]

This doesn't really mean anything, really. The value of stocks is based on the expectation of future earnings, which may not really be related to current earnings - if there is a housing crisis, for example. If you remove the one time charges, the P/E ratios look pretty good.

2008 Apr 02 09:42 PM

[DSX Lover:]

The P/E of Financials is misleading. After Q1 the Trailing P/E is must likely going to be negative because of the writedowns in Q1 and Q4, However, the Forward Looking P/E is going to be the best one among all of the S/P sectors. After the Federal Reserve cuts, banks are printing money, and write-downs, are going to become write-ups, something that most ignorant persons are unwilling to believe. Load on the Banks after they report in March, the kitchen sink quarter, specially on C who's 50% of the earnings come from International Operations, that are not affected by the sub-prime debacle.

2008 Apr 02 11:24 PM

[Mr Mortgage:]

when do 'one time charges' that happen quarter after quarter become recurring charges.

2008 Apr 03 01:41 AM

[VP of Commo...:]

Plus much of the financial sector earnings from 2004-2007Q2 came from products that have a vastly diminshed place in the market.

2008 Apr 03 02:57 AM

[dancing diva:]

Your P/E exercise is misleading and therefore worthless since it conveys the idea the stock market is expensive.

The s&p p/e is high because the "e" in both the financial and consumer discretionary areas have fallen, and these two sectors make up about 29% of the s&p (as of Sept 2007 although it's probably lower today). When one takes a look at the other sectors, where earnings are actually growing because they are heavily tied to the world export market, p/e's are not particularly high on a historical basis and in most cases are lower than a year ago. This was especially true before the latest rally.

2008 Apr 06 12:55 AM

[danimalish:]

So when valuing financial stocks, "recurring" earnings due to increased asset valuation should be given full weight in the analysis.

But recurring non-recurring losses due to asset devaluation should be ignored.

Its like real estate: it only goes up.

The bulls are once again delusional and see only a bull market in the middle of a recession.

2008 Apr 11 02:07 PM

[Chief Debt ...:]

Hmm. I'm still confused.

It looks like there are two possibilities, either P is too high or E is too low.

Then I have a question: If E is enough, why are those banks need capital infusion?

2008 Apr 30 01:19 AM