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Earnings or Multiple Expansion?

Posted By Barry Ritholtz On August 27, 2005 @ 10:01 am In Earnings,Investing,Markets | Comments Disabled

There’s a fascinating analysis (in Barron’s), looking at S&P500 earnings in a very different way than our prior discussions [1] of using year-over-year S&P500 earnings [2] changes as a buy signal [3].

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 [4]. The book also has a website [5];

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



Preparing for Low Returns [6]
Barron’s, MONDAY, AUGUST 29, 2005   

Table Sources:
Author KEITH WIBEL’s projections and Standard & Poor’s data
Trouble Ahead [7]

Barron’s,  MONDAY, AUGUST 29, 2005   

Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2005/08/earnings-or-multiple-expansion/

URLs in this post:

[1] prior discussions: http://bigpicture.typepad.com/comments/2005/02/how_to_use_earn.html

[2] year-over-year S&P500 earnings: http://bigpicture.typepad.com/comments/2004/02/chart_of_the_we_2.html

[3] buy signal: http://bigpicture.typepad.com/comments/2004/02/the_sweet_spot_.html

[4] Unexpected Returns: Understanding Stock Market Cycles: http://www.amazon.com/exec/obidos/ASIN/1879384620/thebigpictu09-20/102-1793806-1323309

[5] website: http://www.crestmontresearch.com/content/Unexpected%20Returns.htm

[6] Preparing for Low Returns: http://online.barrons.com/article/SB112482778471020893.html

[7] Trouble Ahead: http://online.barrons.com/article/SB112509312029524518.html?mod=article-outset-box

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