Do even small amounts of inflation cut into stocks’ value as measured by the price-earnings ratio? Yes, according to research by economist David A. Rosenberg at Merrill Lynch. WSJ: “In an inflationary environment, the hidden value-related pitfall for investors is that as earnings – or “e” in the “p/e” equation – go up, the ratio itself goes down, just as any fraction does when its denominator increases.”
Historical S&P500 P/E
Source: WSJ
The only way to avoid that scenario is if prices-the top number in the equation-keep pace, increasing as quickly as the “e.” That often doesn’t very happen. As earnings growth slows, “damage to the p/e ratio might not be as steep as in previous cycles. But falling values could still scare off enough investors to keep stock prices flat over the next year or so.”
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“Everything in the future is a wave, everything in the past is a particle.”
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hey, why do earnings go down during inflationary periods? why don’t nominal earnings go up?
The market PE is an expression of the present value of a future stream of earnings (dividends).
Higher inflation, (usually accompanied by higher rates) reduces the present value of that future stream of earnings. When you buy a stock you are buying a claim on that future stream of income, and the PE tells you how much you are willing to pay for that claim.
Market timing is almost completely a function of PE changes. The correlation between the change in earnings and the change in the market is essentially zero — ie, it is random — so even if you have perfect knowledge of what earniongs will do it is no help in determining what the market will do.
On the other hand, themarket moves in the same direction as PEs over 90% of the time — if you can be right on the direction of PEs you have over a 90% probability of being right on the direction of the market.
The above question of why do earnings go down in iflationary period is incorrect. Since WW II s&p eps trend growth has been 7%, and there is little or no evidence that it is either higher or lower when inflation varies.
Spence, thats the long term trend — but there have clearly been periods where earnigns have moved 1 or 2 standard deviations away from trend, before mean reversion — and thats not even discussing P/E expansion or contraction.
The trick is catching those moves . . .
Agree completely that trick is catching trend changes in P/E but not EPS. Knowing what eps will be is of little or no help in telling you what the mkt will do. Correlation between a perfect forecast of next years EPS growth and
change in market is 0.2 — you would be better off flipping a coin.
Spencer,
I understand that the correlation between next year’s earnings and the change in the market is very low, but this is partly because market prices currently reflect an estimate of future earnings.
What if you gauged the disparity between the true EPS figure and the market’s *expectation* of next year’s earnings, and then traded based on that analysis? So, if our quantitative model shows that the market expects earnings growth of around 10% but you know earnings will actually be 5%, then you would go short and, in all likelihood, make a profit. Does this make sense? If so, focusing on EPS isn’t necessarily a losing strategy.