Earnings or Multiple Expansion?

There’s a fascinating analysis (in Barron’s), looking at S&P500 earnings in a very different way than our prior discussions of using year-over-year S&P500 earnings changes as a buy signal.

Keith Wibel, an investment adviser at Foothills Asset Management, observes that:

"Over 10-year periods, the major determinant of stock-price returns isn’t growth in corporate profits, but rather changes in price-earnings multiples. The bull market of the 1980s represented a period when multiples in the stock market doubled- then they doubled again in the 1990s. Though earnings of the underlying businesses climbed about 6% per year, stock prices appreciated nearly 14% annually."

I’ve seen other analyses that show well over half, and as much as 80% of the gains of the 1982-2000 Bull market may be attributable to P/E multiple expansion.

Wibel’s piece in Barron’s lends some more weight to this theory that "rising price-earnings multiples are the key driver of stock-price gains, and further, the decline in P/Es since the 1990s bodes ill for equity investors."

Here’s the Historical Data:

S&P 500  
  Annual Change P/E Ratio
Decade EPS Index Beginning Ending
1950s 3.9% 13.6% 7.2 17.7
1960s 5.5 5.1 17.7 15.9
1970s 9.9 1.6 15.9 7.3
1980s 4.4 12.6 7.3 15.4
1990s 7.7 15.3 15.4 30.5
2000s* 4.1 -3.8 30.5 20.7
Average 6.1% 8.1% 7.2 16.4
Projected Figures For
S&P 500 In 2014
  Average High Low
EPS $105.85 $131.16 $81.02
P/E 16.4 23.4 9.4
Level 1735.94 3069.14 761.59
10-Year Growth Rate** 3.5% 9.5% -4.7%
Dividend Yield 1.7% 1.7% 1.7%
Annual Gain*** 5.2% 11.2% -3.0%

*Through Dec. 31, 2004
**Compound rate
***From S&P 500’s level of 1234.18 on July 31, 2005

Even after the multiple compression during the 2000’s from 30 to 20, we are still at relatively high P/Es, at least when compared to prior early Bull market stages. That’s yet another factor which argues against this being anything other than a cyclical Bull market within a secular Bear. Or in plain English, this is not the early stages of a decade plus of market growth.   

Here’s the Ubiq-cerpt:™

"Conventional wisdom states that share prices follow earnings. Over
very long periods, this statement is correct. However, the time
necessary to validate this assertion is much longer than is relevant to
most investors.

In order to test the conventional wisdom, we examined the growth in
earnings in each decade, beginning with the 1950s. We chose 10-year
periods because they’re long enough to allow the cyclical peaks and
valleys to offset each other, yet short enough to be a reasonable
planning horizon for most investors. The results of the study are shown
in one of the accompanying tables.

There is very little correlation between earnings growth and
share-price appreciation. During the 1950s, earnings grew less than 4%
a year, yet that was one of the best decades for stock-price
performance. The 1970s saw the fastest earnings growth in the past 55
years, but that was the worst decade for investors in the stock market.
(Fortunately, the book is still open on the 2000s.)

The average rate of earnings growth clusters around 6% a year,
reflecting growth in the economy which tends to average 3% to 4% per
year. Add 2% to 3% annually for inflation and one is back to
approximately 5% to 7% growth in nominal gross domestic product and the
growth in profits for the companies in the S&P 500 Index.">

Note: I am posting this from sunny Palo Alto, California, about 8 blocks from Steve Jobs house — Pretty cool!


UPDATE  August 30, 2005 10:25 pm

Ed Easterling of Crestmont Research has a book out that is related to the subject of stock market returns and P/Es  called Unexpected Returns: Understanding Stock Market Cycles. The book also has a website;

If anyone has read this, be sure to share your views — but it looks interesting . . .



Preparing for Low Returns
Barron’s, MONDAY, AUGUST 29, 2005   

Table Sources:
Author KEITH WIBEL’s projections and Standard & Poor’s data
Trouble Ahead

Barron’s,  MONDAY, AUGUST 29, 2005   

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What's been said:

Discussions found on the web:
  1. ideogenetic commented on Aug 27

    This correlation (changes in price earnings multiples is the major determinant of stock prices) strikes me like saying it rains because it gets wet, not the other way around.

  2. brian commented on Aug 27

    Can you yell “Hey Steve. Throw me down a Powerbook!” real loud? Sure would appreciate that….

  3. spencer commented on Aug 28

    From 1949 to 2000 earnings accounted for about 27% of the growth in the market and PE changes acounted for 72%.

  4. royce3333 commented on Aug 28

    I must be missing something. We know that some sectors tend to trade at lower multiples than others. We’ve also regularly seen periods where the market is extremely optimistic about earnings growth or extremely pessimistic. How could this sentiment not affect returns? We see the same thing in housing prices now as people are willing to take on huge levels of debt based on a belief that house prices offer stable groth and security.

  5. Barry Ritholtz commented on Aug 28

    ideogenetic —

    the key point is that markets rose not in response to earnings improvement — but rather, due to the mass psychology that allowed stocks that were historically expensive P/E wise to purchased anyway . . .

    Stock could have gone up due to improved earnings — but since earnings didn’t much improve . . .

  6. kennycan commented on Aug 29

    Judging from the 1970’s I wonder how much the correlation would improve if real earnings, ie earnings that were adjusted for inflation, were used. Note the 1980s and 90s had disinflation whereas the 60s and 70s had accelerating inflation. Perhaps P/E multiples and inflation rates move opposite each other.

  7. spencer commented on Aug 29

    kennycan — you hit it on the head — pe & inflation are negatively correlated.

    but rates are more important. A simple rule of thumb that worked very well since 1960, except in the late 1990s is:

    pe =21 less fed funds

  8. dude commented on Aug 29

    I’ve read some stuff that suggests that stocks will not yield such high growth(as the 80’s and 90’s) over the next couple of decades or so because the P/E ratio would have to rise to something like 80 for the average stock in order to provide similar levels of growth as compared to the 80’s and 90’s. unless, of course, profits rose much higher than in previous yearsm which is not expected. …though you never know how the explosion of technology will afect things :-)

    (EDITOR: What Stuff? Please cite a link!)

  9. rob commented on Aug 29

    unless everyone dumps their house, or vacation house, or both, I don’t see where the money will come from to provide for multiple expansion like we saw in the 80’s and 90’s. The cash is in the dirt now and only a new technology that can galvanise public interest will bring it back to equities. This market lacks anything interesting on the level of the computer/internet theme of the great bull market of the last millenium.

  10. dsquared commented on Aug 30

    My sympathies are with ideogenetic on this one; there are a million of these PE ratio studies and all they’re really showing is that stock prices have more variance than earnings.

  11. Brian commented on Sep 2

    There was a study of the components of historical equity returns – income, inflation, EPS growth and P/E expansion:
    http://viking.som.yale.edu/finance.center/pdf/Supply(v5).pdf (big PDF)
    They come up with:
    Inflation – 3.1%
    Income – 4.3%
    Real EPS growth – 1.7%
    P/E expansion – 1.3%

  12. John commented on Sep 4

    I have read “Unexpected Returns”. While it is a bit repetitive and rambling at times, it does lay out an interesting framework for viewing market cycles. It makes a compelling case for recession over the next few years. There are some pretty cool charts in there too. Some in color, no less.

  13. gautam commented on Apr 29

    Fascinating article and a great read!
    One would think that there would be a strong (inverse) correlation between P/E multiples and bond interest rates. With 10 year rates at 5% this would translate to a risk-free P/E ratio of 20. Could increasing inflation and interest rates account for the contraction in P/E multiples during the seventies, for example? With long term interest rates set to rise, could this continue a shrinking trend in multiples?

  14. Chris commented on Jun 5

    P and E is a real dollars. The 10 year is in nominal. The real interest rate is closer to 2.5%.

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