May 28, 2009

PE Valuation Cycles

I tend to view markets in PE cycles rather than most widely used price cycles of bear and bull markets. This means I follow PE expansion and compression cycles. Why? As investor and I look at valuation to allocate capital rather than price. Moreover, capital appreciation or return is made up from two sources: PE expansion and earning growth. So it follows that PE trends should determine bear and bull markets rather than price action. 

For the purpose of this post there are two cycles an PE expansion cycle and PE compression cycle. There has been 8 secular cycles, including this one, measured from PE trough to peak, throughout the period from late 1800. There were 4 PE expansion cycles and 4 compression cycles, including this one from 2000 to date. 

I used Prof. Robert Shiller data for my analysis and the most interesting findings are in the following table:

Here are few observations:
  • There are secular cycles lasting many years from PE trough to PE peak and vice versa.
  • 10 yr Yield peak and trough coincide with PE cycles; rising yields does impact valuation. So the prospect of rising yields in today's market will negatively impact equity valuation.
  • Average PE compression cycles is some 13 years; we are 9 years in this cycle.
  • Average annualized returns associated with PE compression cycles is almost double the upside move in the PE expansion cycle, -17% vs 10%.

Here are some valuation implications, if I use typical cycles averages to the current PE compression cycle:
  • According to the data, the long term average of PE of 16.34x, it seems that at the current market levels the S&P is fairly valued at 15x.
  • Given the size of the credit event occurred in 2008 and the disruption to world economy also the succession of various bubbles: Internet, housing and credit, a retrenchment in PE by 80% is realistic. So far PE compression is 65% from its 2000 peak. In the secular PE compression seems that a move of 80% down is typical. Therefore another 15% compression is highly likely. 
  • The current compression cycle should end around 8-9 times 10 years real earnings, as most compression cycles ended in single digits. If we use the current S&P 10 yr earnings of $57.67 per share then that puts the price target of the S&P at 519, some 40% decline from the current level.
  • There is an expected Bear market in treasuries due to high supply of paper as governments to try to finance deficits, thereby increasing yield, another sign of secular PE compression, as any PE. 
Although history does not repeat itself but it rhymes. History can rewrite the averages here, but events that transpired are not unique to history and has occurred in the past, so we will work them out. And equities will experience another bull market, but I doubt it is going to be now.

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