Is this Time Different? History Says No

By Chris Puplava, April 5, 2006

Recently I commented on the valuation of the S&P 500 sectors using the Ford Equity Research Graphs that use PE valuation bands over set time frames. I commented on the different sector earnings trends seen by the direction and slope of the earnings bands and wanted to follow up with why those earnings trends were occurring. I looked at the sector's respective sales figures to shed some light on the earnings trend as well as to compare apples to apples by normalizing each sector's sales figures.

To do this I took the top ten market cap stocks in each S&P sector and made a table of their sales figures for each quarter since 2001 (note that the Telecom Index has only 8 companies). I then took the sum of the sales for the ten stocks for each quarter and normalized the data to the first quarter of 2001, where the first quarter of 2001 represents 100. Taking each sector I made a chart with all the S&P sectors for comparison of sales growth since 1st Q 2001. The results are summarized in the chart below.

Figure 1.

The most obvious observation from the chart above is the disparity between the sales growth of the S&P 500 Energy sector compared to all the rest. Sales for the energy sector have risen more than 250% since 1st Q 2001 while the remaining sectors have grown less than 150% of 1st Q 2001 sales. A second observation from the chart above is that, although most sectors aggregate sales appear to be flattening or even declining, energy sales appear to be accelerating exponentially just like their earnings trend seen in the energy PE bands from my last wrap up chart. To get a better picture of the remaining sectors� earnings I removed energy and plotted the chart below.

Figure 2.

In my last WrapUp I commented that the utility sector was overvalued on a 10-year and 3-year basis, and that earnings have been flat as seen by the utility sector's flat earnings trend bands in its 3-year chart. This observation makes sense when looking at the utility sector's sales performance from 1st Q 2001. Sales initially plummeted 50% by April 2002 and have remained relatively flat since then, never recovering to the sales level of 1st Q 2001. Because of the poor sales performance, and thus earnings performance, the PE ratio for utilities has risen since the beginning of the current bull market predominantly from price appreciation and not earnings growth. This implies that the price movement in utilities has been entirely speculative driven, in stark contrast to energy stock appreciation where earnings have outgrown price appreciation and have actually DRIVEN DOWN the PE ratio.

Another observation I made in my last WrapUp was the stable earnings trend of the healthcare and consumer staples sectors, both defensive sectors. After energy, both healthcare and consumer staples have seen the highest sales growth since 1st Q 2001, and the consumer staples sector saw the smallest decline over the 5-year period. Both groups have displayed stable sales growth figures as seen by their relatively straight trends in the chart above.

What I really want to comment from here on is the historical valuation of the S&P 500. After my last WrapUp I received the following e-mail:

�Chris - I remember when the range for P/E's was between 7 on the low and 21 on the high with the median being 14. What has changed? My glance tells me you believe equities are undervalued. Yet most P/E's are way above 14 with many above 21. Seems to me things are still pricy. Oh ya, and the yields were 5-10%. Your thoughts in your next column would be great!!!�

The writer informed me that he is a CFP who started in the business in 1981 �when no one wanted to buy XON and TX at 7 PE�s and 10% yields.� Less than two years ago I was a lab rat working at Pfizer in San Diego without any business background. When reviewing the 10-year Ford PE charts of the S&P 500 with an upper PE of 30 and a lower PE of 16, the current PE near 18.6 on the S&P seemed to me to indicate the markets were relatively undervalued due to my short time frame in the financial business.

Last night I reviewed some interesting publications from economists from Harvard, Yale, and the Federal Reserve Bank of Kansas City. I was particularly interested in the article entitled, �Valuation Ratios and the Long-Run Stock Market Outlook," by Yale economic professor Robert J. Shiller and Harvard economic professor John Y. Campbell. Their study was published in 1998 in which the authors reviewed the S&P 500�s historical valuation and the markets returns after various PE ratios. The authors believe the markets were overvalued at that time when reviewing their past data on the S&P 500. The authors later published an update to their 1998 work in early 2001 (PDF link). In their update the authors commentated that;

�On December 3, 1996, we testified before the Federal Reserve Board that, despite all the evidence that stock returns are hard to forecast in the short run, this simple theory of mean reversion is basically right and does indeed imply a poor long-run stock market outlook. We amplified our testimony and published it in 1998, continuing to assert our pessimistic long-run scenario.�

They further added that:

�The stock market did not immediately move to encourage faith in our theory. Since our testimony, the stock market, as measured by the real (inflation-corrected) Standard & Poor Composite index, has increased by 80% above its value when we testified, and 30% above its value when we published.

Despite these developments, we believe that our original testimony and article are even more relevant today. Valuation ratios moved up in the year 2000 to levels that were absolutely unprecedented, and are still nearly as high as of this writing at the beginning of 2001. Even allowing for the possibility that the economy and financial markets have undergone some structural changes, these ratios imply a stronger case for a poor stock market outlook than has ever been seen before.�

The authors were proved right in there analysis and were even more convinced as they saw the market appreciate 80% since their testimony before the Fed. I ran across another article entitled, �The P/E Ratio and Stock Market Performance,� by Pu Shen, senior economist in the research department of the Federal Reserve Bank of Kansas City (PDF link), written in 2000. The author commented on the work done by Campbell and Shiller that showed strong historical evidence that high PE ratios have been followed by disappointing stock market performance in the short and long term. Specifically, high price-earnings ratios have been followed by slow long-run growth in stock prices. Additionally, when high price-earnings ratios have reduced the earnings yield on stocks relative to returns on other investments, short-run stock market performance has suffered as well.

Shen comments that �Despite this evidence, however, we cannot rule out the possibility that these historical relationships are of little relevance today due to fundamental changes in the economy.� His article was written at the height of the last bull market!

I'd now like to present some of the work by Campbell and Shiller that is presented in the article by Shen. Below is the historical PE ratio of the S&P 500.

Figure 3.

Source: The P/E Ratio and Stock Market Performance,� by Pu Shen, (PDF link)

With the average PE ratio of 14.5, when ever the market reached extremes on the low or high end, the markets mean-reverted back to the average. Note the dramatic rise seen in the last bull market with a PE more than two fold greater than the average. Mean reversion of a high PE back towards its average can occur in two ways; either the price falls faster than earnings or earnings rise faster than price. Of these two routes only a drop in prices implied a negative market outlook.

To test which route typically occurred during high PE valuation periods, Campbell and Shiller compared the PE ratio of the S&P 500 at the beginning of a year and plotted the annualized real index return over the following ten years, and the annualized change in real earnings for the index following ten years. Their hypothesis is summarized below by Shen�s comments:

�If movements in the P/E ratio back toward the average occurred through changes in stock price growth, years with high P/E ratios should be years with low subsequent growth in stock prices. On the other hand, if movements in the P/E ratio back toward the average occurred through changes in earnings growth, years with high P/E ratios should be years with high subsequent growth in earnings.�

The results of Campbell and Shiller�s analysis revealed that higher PE ratios in the S&P 500 are followed usually by lower stock price growth during the following decade and are usually NOT followed by faster earnings growth. The graphs are given below:

Figure 4.

Figure 5.

Source: The P/E Ratio and Stock Market Performance,� by Pu Shen, (PDF link)

What can be seen in Figure 4 of the trend in the S&P price with given PE ratios is a clear inverse relationship with a negative slope (negative correlation) confirming the authors hypothesis that high PE ratios (X-axis, far right) were followed by low stock market returns (Y-axis). Figure 5 shows a relatively flat relationship (zero correlation) with earnings growth and the S&P PE ratio as the earnings growth were scattered above and below 0% growth. The conclusion drawn from both graphs is that the movement of the PE ratio back toward the long-term average occurred primarily from changes in the index�s price and not earnings growth.

Campbell and Shiller published their update in 2001 to their 1998 study using the most recent data at that time (PDF link). The PE ratio to subsequent S&P price appreciation is given below, though slightly modified. The authors took the PE ratio at each time point and divided it by the 10-year PE moving average to smooth out the results.

Figure 6.

The negative correlation between the PE ratio and the 10-year price growth is clearly evident. The modified PE ratio of 1929 corresponded to roughly a -0.4% 10-year annualized index return. Note where the 2000 modified PE ratio is located, right on the trend line with a modified PE of 44.9 which corresponded to a -0.9% 10-year annualized index return.

Shen put forth in his article the main arguments from analysts as to why things were different in 2000 and the �New Era.� The first argument is faster earnings growth. The argument by analysts according to Shen was that�

�If earnings are expected to grow persistently faster than previously, it is only natural that investors be willing to pay more for stocks and thus raise the P/E ratio. Many analysts believe that the U.S. economy has entered a �New Era,� in which globalization and accelerated technological progress will allow the economy to grow faster than in the past. Further, they believe that in this New Era faster economic growth will translate into faster corporate earnings growth for a long time to come. Some believers in the New Era argue that the recent increase in GDP and earnings growth is permanent because it reflects the spread of new information and communications technology.�

Shiller published a book in 2000 entitled �Irrational Exuberance.� In his book he made the argument that the dramatic growth in the S&P 500 and the Dow Jones Industrial Average in the latter half of the 90�s far outgrew the corporate earnings gains as well as economic gains and productivity. According to Shiller the argument by analysts of sustained earnings growth is not likely. In his book he made the following remarks:

�An unprecedented increase just before the start of the new millennium has brought the market to this great height. The Dow Jones Industrial Average (from here on, the Dow for short) stood at around 3,600 in early 1994. By 1999, it had passed 11,000, more than tripling in five years, a total increase in stock market prices of over 200%. At the start of 2000, the Dow passed 11,700. However, over the same period, basic economic indicators did not come close to tripling. U.S. personal income and gross domestic product rose less than 30%, and almost half of this increase was due to inflation. Corporate profits rose less than 60%, and that from a temporary recession-depressed base. Viewed in the light of these figures, the stock price increase appears unwarranted and, certainly by historical standards, unlikely to persist.�

There is more great information from Shiller, but to wrap up this WrapUp please go to the following link to read an excerpt from Shiller�s book: Irrational Exuberance.

Where are we today? To look at how the current market valuations stack up against historical valuations I have pasted below charts from Shiller�s book from updated information Shiller provides on the following site: Irrational Exuberance Update.

Figure 7.

Figure 8.

The current S&P 500 PE ratio of 18.27 is above the average PE of 14.5, though not quite as high as the 2000 tech bubble burst or the 1929 crash. When looking at Figure 6, a PE ratio of 18.27 would correspond to roughly a 0% 10-year annualized index return. As the data suggests flat earnings from the S&P 500, it makes sense to overweight portfolios in the sectors that are experiencing rapid sales and earnings growth with the S&P 500 energy sector clearly the front running candidate.

Market Wrap Up

Please forgive the short wrap up for today's market as I ran out of time�.

Index Summary

Index	Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Dow Jones Industrial Avg.	11,239.55	35.70	0.3%	1.2%	2.0%
S&P Dep. Receipts	131.06	0.50	0.4%	1.0%	2.3%
Nasdaq Composite Index	2,359.75	14.39	0.6%	0.9%	2.5%
Nasdaq 100 Trust	42.61	0.40	0.9%	1.6%	3.7%
Dow Jones Transportation Avg.	4,726.59	44.78	1.0%	3.5%	4.8%
Dow Jones Utility Avg.	398.63	3.88	1.0%	2.5%	-3.2%
Inter@ctive Internet Index	191.49	0.57	0.3%	1.2%	3.8%

Sector Summary

Description	Last Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Basic Materials	1,539,108	21,963	1.4%	4.1%	10.0%
Capital Goods	825,139	9,973	1.2%	2.8%	7.0%
Conglomerates	856,086	-2,414	-0.3%	0.2%	4.8%
Consumer Cyclical	913,273	10,131	1.1%	2.0%	6.3%
Consumer/Non-Cyclical	1,373,411	49	0.0%	0.7%	0.9%
Energy	2,981,587	36,942	1.3%	3.1%	6.8%
Financial	5,610,939	18,621	0.3%	1.5%	2.9%
Healthcare	2,385,609	-4,842	-0.2%	-0.2%	1.6%
Services	4,738,774	17,649	0.4%	0.8%	2.2%
Technology	3,394,834	31,987	1.0%	1.8%	4.4%
Transportation	470,506	2,935	0.6%	2.5%	5.6%
Utilities	975,413	7,421	0.8%	2.3%	1.8%

Industry Gains & Pains

Industry Group	Today's Mkt. Cap.	Today's Mkt. Cap. Chg.	Today's % Price Change	Week to Date % Price Change	1 Month %Price Change
Industry Groups with the Greatest Gain in Mkt. Cap. Today
Metal Mining	554,269	15,662	2.9%	7.3%	16.7%
Semiconductors	660,637	12,290	1.9%	2.9%	2.1%
Auto & Truck Manufacturers	477,079	7,700	1.6%	2.8%	7.5%
Oil & Gas Operations	661,871	8,646	1.3%	2.9%	5.9%
Oil & Gas - Integrated	1,883,885	21,357	1.1%	3.0%	6.3%
Industry Groups with the Greatest Loss in Mkt. Cap Today
Medical Equipment & Supplies	332,209	-3,377	-1.0%	-1.1%	-1.8%
Personal & Household Prods.	303,185	-1,633	-0.5%	0.2%	-1.1%
Business Services	245,419	-1,199	-0.5%	-0.2%	1.8%
Conglomerates	856,086	-2,414	-0.3%	0.2%	4.8%
Biotechnology & Drugs	770,440	-1,558	-0.2%	-0.8%	1.6%

Have a pleasant weekend,

Chris Puplava

Contact Information

Christopher M. Puplava
PFS Group
PO Box 503147
San Diego, CA 92150-3147
(888) 486-3939 Toll Free
(858) 487-3939 Tel
(858) 487-3969 Fax
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