FSO Editorials

The Stock Market P/E Ratio Continues to Decline More than Earnings

Can it possibly rise during 2006 and thereafter?

by Bob Bronson, Bronson Capital Markets Research. March 13, 2006

The stock market is a mix of growth and cyclical (value) company stocks whose P/E ratios move confoundedly in opposite directions.

Because the earnings of growth companies are always growing by definition -- albeit at faster or slower rates -- their P/E ratios are always positive, even as they vary over (national) business cycles.

By definition, the earnings of cyclical companies (in the denominator) are very volatile -- rising and falling faster than their stock price -- so over a (national) business cycle their P/E ratios move in the opposite direction to those of growth companies.

For example, when cyclical companies' earnings decline towards zero, their P/E ratio approaches infinity; and when they turn negative, their P/E ratios become meaningless.

Of course, when growth companies become mature, they become more cyclical, or more sensitive to the national business cycle, and then most corporate managements try to trim expenses and/or add growth divisions to offset the increasing cyclicality of their business model. Thus, most companies are a constantly changing mix of growth and cyclicality.

Because the whole stock market is a mix of a small portion of pure growth, another small portion of pure cyclical companies, and a majority of companies that are a mixture of both, predicting the stock market's P/E ratio from the bottom up (company by company, industry by industry and sector by sector) is a complex process.

But from a top down point of view, (total) market P/E ratios can be reasonably predicted, both longer-term based on their intrinsic Supercycle reversionary nature, which we demonstrate in our P/E Predictor Study 1, and on a shorter-term basis using key fundamental predictor factors, which we present in our P/E Predictor Study 2.

Changes in the stock market's P/E ratio are more important than changes in corporate earnings as demonstrated during the past 5.75 years:

Here's the latest update of our Supercycle P/E expectations:

click to enlarge

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© 2006 Bob Bronson

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Bob Bronson | Bronson Capital Markets Research | Email

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