Stock Market Investing - The Case For Expanding PE Ratio

By: Hans_Wagner

Knowing whether the PE ratio is going to expand or contract is an important factor when trying to beat the market . This is the second of a four part series on which direction the PE ratio for the S&P 500 will go over the next couple of years. Last week we briefly went over how to use the PE ratio and then we will look at ways to get the underlying PE ratio for the S&P 500. It is not as easy as one might first think. In the later parts we will examine the potential for the S&P 500 PE ratio to expand, contract and then provide an opinion on what investors should do. You can read the first commentary at Will the PE Ratio Expand or Contract? Part 1 . For those readers interested in learning more on how to predict macro moves in the market check out Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis.

The PE Ratio of the is near a Low

Buying the right stock at the right price is vital if you want to beat the market. According to many investment advisors the right price corresponds with a low PR ratio. When the PE ratio is low for the market you are likely close to a bottom, which is a great place to buy. As Sir John Templeton, a noted investment advisor and founder of Templeton Funds, says “Buy bargains.”

The chart below, from Ticker Sense , shows an interest perspective of the S&P 500 PE ratio and the value of the S&P 500. Notice that the PE ratio has declined from a high of 60 in 2001 to below 20 in 2007. Meanwhile the price of the S&P 500 has risen to reach its all time high. This divergence implies that the PE ratio has room to expand. Just keep in mind this doesn't mean that the PE ratio is near a low, since this is usually closer to 10.

The Earnings Yield

The S&P 500 current P/E ratio of about 17 means that investors are willing to pay $17 dollars for every dollar of annual profit generated by the companies that make up the S&P 500 index. The inverse of the P/E ratio is the earnings yield, which is currently at about 5.9% (1/17). The earnings yield is an important measurement, since it helps investors compare the yield on stocks versus the yield on safer government bonds which is currently around 4.5% for 10 year notes. In other words, what yield would entice investors enough to invest in a riskier investment such as stocks versus a lower risk investment such as government bonds? 

Now if rates were to fall to 4% it would give room for the PE ratio to rise to 20, or an earnings yield of 5%. Which raises the question, will interest rates go higher or will they go lower? 

One thing in favor of lower interest rates is the current inflation expectations which are now very close to the U.S. Federal Reserve's target of 1 – 2 %. Right now there are a number of analysts that believe the Fed will lower rates sometime in the next 6 – 9 months. Should this happen it would drive the PE ratio higher.

Global Economies Driving Growth

Another reason for the PE ratio to expand is when growth expectations are higher. We are experiencing dramatic growth in many of the world's economies including the BRIC countries of Brazil, Russia, India and China as well as Eastern Europe, and Latin America. Also, the high price of oil is helping to drive growth for all the countries that supply the world's oil. This activity is helping to drive up the growth rates of companies that are in a position to deliver the goods and services for these economies. According to one study approximately 44% of the earnings of companies in the S&P 500 in 2006 are from countries outside of the United States. This figure is certainly higher in 2007.

As the market continues to realize the strength of this growth and its impact on the financial performance of the companies that are participating, it is likely that the PE ratio will expand from its current level. 

The Bottom Line

The current market can continue to rise on the growth of earnings alone. However, there are several important reasons to expect the PE ratio to expand from its current level. For one it has fallen from its lofty highs of 2001 even while the market has grown since 2003. Also, the U.S. Federal Reserve could have reasons to lower their rates in the next 6 to 9 months as inflation comes under more control and the U.S. economy continues to slow. And finally, the continued strength of the global economy will drive growth in earnings of the companies that are participating. This will also cause the PE ratio of the S&P 500 to expand. The expansion of the PE ratio will help to power the market higher. 

Next week I will make the case for a contraction of the PE ratio. Then in the following week, I will offer my view of what investors should do.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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