Tuesday, July 5, 2011
I've been pushing this theme for a long time, and the point is to show that the market is still gripped more by pessimism than by optimism. This is a market that is very reluctant to accept that things have improved and very quick to believe that conditions are going to deteriorate. For investors who believe that there will be no deterioration, rather just a continuation of the (unimpressive) status quo or perhaps some modest improvement in the future, this makes today's valuations attractive.
The top chart shows that PE ratios remain below their long-term average, using data as of June 30. The bottom chart compares the earnings yield (the ratio of per-share profits to share price) on equities to the yield on BAA corporate bonds (which is representative of a significant share of the large cap corporate universe). For the past year, earnings yields have been higher than corporate bond yields, a condition that is a relatively rare occurrence. Ordinarily, investors are willing to accept a lower yield on equity ownership than they could receive by buying a corporate bond, because equity ownership can deliver capital gains in addition to the earnings yield. That investors today seem largely indifferent to these two valuation metrics is a sign that the market doesn't see much chance, if any, of future capital gains.
To be fair, I should note that the growth of earnings has slowed considerably this year, as evidenced by the chart above. Over the past six months, profits growth has slowed to an 8.1% annualized pace. But I would also note that an earnings growth slowdown does not necessarily foreshadow a recession (e.g., 1986-87), nor does relatively slow earnings growth preclude an ongoing rise in equity prices (e.g., 1996-1999). So while the market may be correct to suspect that earnings growth could be well below the double-digit range for the foreseeable future, this is not a death knell for the economy or the stock market. After all, earnings growth has averaged 6% per year over the past 50 years.
Posted by Scott Grannis at 11:06 AM