Sluggish Price/Earnings Ratios Could Threaten Rally

Stock market bulls have at least two reasons for optimism: Corporate earnings have continued to climb, and sentiment on Wall Street has improved sharply in the last several weeks.


In theory, this could provide more fuel for the stock market rally. After all, not only are earnings climbing, but the price that investors are willing to pay for those profits could also start to rise. And most investors now say they are optimistic about stocks, according to the American Association of Individual Investors.

Yet there’s a problem with this argument: Price-to-earnings ratios based on current year earnings haven’t been rising lately. According to Standard & Poor’s, the P/E for the S.& P. 500-stock index, based on 2011 estimated operating earnings, stands at 13.3, down from the 15.1 at this time last year, based on 2010 estimated profits.

The situation has set off a Wall Street debate over whether investors should count on market valuations to rise at all this year. In fact, some strategists are even hinting that P/Es could slump, which would create a major headwind for this rally.

To be sure, taken as a group, investors are moving money back into stocks. After yanking $182 billion out of stock mutual funds between January 2007 and last November, they have put more than $3 billion back into equity portfolios since December. And greater demand for stocks should drive market multiples higher.

But Jeffrey N. Kleintop, chief market strategist at LPL Financial, said a $3 billion inflow is still a modest sum by historical standards and that he doesn’t expect strong inflows into stock funds this year.

Moreover, he said Americans’ new investments in stocks could be offset if foreign investors become more squeamish about the United States market. He noted that stocks “have been relying more on foreign investors to support valuations in recent years.”

Although the S.& P. 500, in dollar terms, posted a strong double-digit gain in the second half of 2010, it was up significantly less in euros and yen. That could make foreign investors question whether they should invest heavily in the American market.

And while earnings have continued to rise, the pace of that growth has slowed as the recovery has matured. That could also keep P/E ratios in check, Mr. Kleintop added.

Adam S. Parker, domestic equity strategist at Morgan Stanley, agrees. In a recent strategy report, Mr. Parker noted a historical relationship between slowing earnings growth rates and lower market valuations. Since 1976, for example, when corporate profits have grown at a rate of 11 to 12 percent, the average P/E based on estimated earnings for the next 12 months has been 15.7. But when that profit growth slows to the 9 to 10 percent range, those P/E’s have historically fallen to around 11.

Mr. Parker said he believes that by the middle to the end of 2011, investor expectations for year-over-year profit growth will be lower than today’s consensus estimate of 12 percent. “As such, the market multiple, in our estimation, is more likely to contract than expand over the medium to long term,” unless profit growth reaccelerates in 2012, he wrote last week.

There’s yet another reason to worry that P/E’s may contract. Let’s assume that market bulls are correct and that the economy is well on the way to recovery, with a successful jump-start from policy makers. One would expect inflation and interest rates to rise, as they are natural byproducts of an expanding economy.

The problem is that higher inflation has generally led to lower market P/E ratios, because inflation eats away at the value of each dollar in corporate earnings.

Duncan W. Richardson, chief equity investment officer at Eaton Vance, says that while there is a fundamental relationship between inflation and stock market valuations, current levels of inflation are so low that there is no reason to panic. “As long as inflation still hovers in the 1 to 3 percent range, that’s actually a good time for P/E multiples,” he said.

Indeed, since 1871, the market’s P/E has hovered between 17 and 18, on average, in periods when inflation has grown at an annual rate of 1 to 3 percent. That’s well above the current P/E of about 13.

But what about the potential for rising market interest rates? Couldn’t higher rates pressure P/E ratios, by making bonds more attractive than stocks?

In general, the answer is yes, but Liz Ann Sonders, chief investment strategist at Charles Schwab, points out that bond yields are still low by historical standards.

And even though there’s a strong correlation between rising bond yields and falling P/E’s, that’s not necessarily the case when the yield on 10-year Treasury securities is below 5 percent. Ten-year yields today are still only 3.3 percent.

“Yields are at a low-enough absolute level where it’s not yet threatening P/E’s,” Ms. Sonders said.

AT some point, of course, that may no longer be the case. But Mr. Richardson said sufficiently high inflation and interest rates are “late 2011 or 2012 issues.” In the meantime, he said, “investors can still be excited about stocks based on earnings growth alone.”

If market valuations contract, corporate America could still keep the rally going by meeting and exceeding profit expectations, he said. And if market multiples expand? “That would be icing on the cake,” he added.