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Contributors: Douglas McIntyre Jon C. Ogg

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Thursday, September 28, 2006

P/E Wave Meme Meets Wall Street Journal

By William Trent, CFA of Stock Market Beat

We have frequently expressed our belief that stock market valuations are undergoing a long-term contraction. Although many interpret this to mean that we expect lower values (as in a decline in major benchmarks) that doesn’t have to be the case. From 1968-1982 the market traded more or less sideways because the valuations (multiples paid on earnings) declined about as fast as the earnings themselves grew.

Now the theory has gone about as mainstream as you can get, with SeekingAlpha’s summary of the Wall Street Journal indicating that the most famous source of market news has a story on the topic.

How Price/Earnings Will Impact the Dow: Financial News - Yahoo! Finance

Can stock prices continue to rise? Two potential bullish resolutions: 1) Earnings soar, taking prices with them. This is unlikely; we have already seen four consecutive years of strong earnings growth, and profits margins are at record numbers. 2) Earnings remain stable, but investors fork-out ever-higher prices to buy-in to their favorite stocks, driving P/E up. This is similar to what happened in the 1994-2000 run up. But then, a) long-term interest rates were plummeting — today it seems unlikely they can fall much more, and b) there was an insatiable hunger to get into the markets — since dampened by the aftertaste of the ensuing bear. Says Byron Wien, chief investment strategist at Pequot Capital Management, “My view is that both earnings and interest rates will be pushing against you.”

Our point exactly.

The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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