Reconsidering P/E Contractions: What Goes Up Must Stay Sideways?

 |  Includes: DIA, QQQ, SPY
by: William Trent, CFA

I have not written in some time about a theme that I think is an important one. Skeptics could probably argue that the reason I haven’t written about it was that the recent facts have contradicted my belief, though the fact is just that I haven’t gotten around to it. So, to put the cards back on the table, it is time to talk about valuation cycles.

Many people can tell you that the average market P/E over the long term is something like 15 times. Of course, “average” doesn’t imply that the P/E is always 15. About half the time it is higher, and about half the time it is lower. The trick is figuring out in advance which half is which.

In behavioral finance, some would argue that the market follows long-term trends in valuation. Rising valuations spark investor interest, and additional investors adding money to the market causes further increases in valuation. Once all investors are in the market, though, valuations peak. As they begin to decline, investors gradually lose interest and start pulling money out of the market, further causing valuations to decline.

The theory would explain why, despite profits following a fairly regular 7% annual growth rate, the market tends to have large advances followed by long periods of sideways movement.

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Source: Barron’s, via The Big Picture.

Extending that to the current period, a 15-20 year period of sideways prices and/or declining valuations would have started sometime between 1998 and 2000.

Econoday recently updated the S&P 500 quarterly data for both profits and stock prices, saying:

Stock prices have lagged profits throughout the expansion, showing declines early on for five straight quarters in 2002 and 2003 even while profits were moving ahead and then exceeding profits for another five straight quarters in 2006 and 2007 even while profits began to contract. As of this writing, the S&P for April is down 6 percent year-on-year, indicated by the last red bar on the right of the graph. Profits have not been supporting share prices for more than a year, an unsustainable disconnect between profits and shares that hints at big losses in the stock market should the big expectations for future profits fizzle out. Even if companies do meet the expectations, stock prices are not necessarily going to follow higher right away.

Five straight quarters of increasing valuations (if prices are rising faster than earnings, valuations must be getting higher) is enough to pose a serious challenge to the notion of a long-term cyclical trend, but it also isn’t quite enough to make me abandon the belief. That said, if valuations don’t resume a downward trend sometime this year, continuing to believe in a downward cycle would start to look more like stubbornness than reason.