Sunday, August 14, 2011 1 comments

Sunday Spectacle CXXXV

Rolling 20-year Returns vs Starting P/E Ratio
(click to enlarge)

(source: "Generation Returns," Crestmont Research. Last updated 2010.)

Bull markets don't start from high P/E values; that's one reason the market has been in a bear market for the last 10 years or so. Right now, the P/E ratio appears to have dropped to the level that it was in back in 1989.

Having said that, P/E ratio is influenced by inflation. Typically the P/E ratio tends to be low—that is, market attaches low valuation to business worth—if inflation is high or negative (i.e. deflation). The inverse relationship between P/E ratio and inflation is very clear in the graphic below from Crestmont Research.

Inflation vs P/E Ratio
(click to enlarge)
(source: "P/E Ratios & Inflation," Crestmont Research. Last updated 2010.)

Whether stocks are cheap or not (note that I am talking about the market as a whole and not necessarily specific stocks) depend on what the actual inflation ends up being. If inflation is high or negative, P/E will contract further and possibly result in capital losses. If inflation stays low, then the current P/E, which is similar to what it was in 1989, is fairly reasonable.

Over the last 50 or so years, a positive inflation expectation has always been the right call. Though, right now, my feeling is that the inflation call is very difficult. Deflation is a real threat for the first time in 50 years (just last week, Federal Reserve took the unprecedented(?) step of committing to keep rates really low for around 2 years, which some of you may recall was what Paul Krugman has suggested in the past to battle deflation i.e. market participants need to be "ensured" positive inflation expectation). US nominal GDP actually contracted by -2% in 2009, which happens to be the first time in over 60 years (prior to this, it was in 1949 when GDP nominal growth was -1%). So what we are seeing is certainly something that has been uncommon over the last 50 years.

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