*This post is excerpted from **Probable Outcomes: Secular Stock Market Insights ** by Ed Easterling, released January 14, 2011. *

**P/E Insights**

The price/earnings ratio (P/E) is the investment industry’s attempt to provide a single, simple measure of valuation for stocks and the stock market. P/E does provide an understandable way to translate the previous discussion about present value into a single number. The result is a tool that can provide valuable insights about fair value as well as future returns. As with any tool, it should be used appropriately and with awareness.

If P/E rarely changed over time, or if it changed randomly, then P/E would be nothing more than a phenomenon. Instead, the fundamentally driven cycle of P/E causes secular stock market cycles and determines whether the stock market has the potential for above-average or below-average returns. A more in-depth discussion of its nuances will clarify the outlook for the probable outcomes for stock market returns over this decade.

Figure 7.1, known as the Y Curve Effect, is a plot of the inflation rate and P/E for each year from 1900 to 2009. Historically, years with higher inflation and deflation tended to have a low P/E. During periods of relatively low inflation, P/E tended to peak in the low to mid-20s. The highest points to the right side of the graph reflect the late 1990s bubble, which is not a likely or reasonable assumption for the future. Why does the Y Curve Effect occur?

This discussion starts by applying the concepts and principles to bonds as financial assets. The inflation rate drives bond yields higher because investors demand compensation for inflation. As inflation rises, thereby increasing the yields of bond, the value of existing bonds with fixed interest rates declines. This is the function of present value. The decline in the price of the bond represents a loss in value to its investor until the bond matures. The buyers of bonds, however, can now purchase bonds in the market at lower prices, reflecting higher yields, to compensate for the increase in inflation. The key point to remember: higher inflation drives higher bond yields, which decreases existing bond prices.

**Figure 7.1. The Y Curve Effect: P/E and Inflation (1900–2009)**

Likewise, since stocks are financial assets, higher inflation drives stock prices lower. The effect of the inflation rate on the discount rate is greater than the effect of the inflation rate on earnings. The inflation rate does not always transfer completely into earnings growth. Further, the increase in inflation and the related economic uncertainty can increase the discount rate by more than the inflation rate through an increase in the risk premium that is embedded in the discount rate.

Similar to bonds, the higher discount rate from inflation therefore causes the current prices of stocks to decline as the present value of future earnings declines. Since stocks have no maturity, there is a loss in value to the owners of the stocks. The buyers of stocks, however, can now purchase stocks in the market at lower prices, reflecting a higher expected future return, to compensate for the increase in inflation.

In deflation, the value of a bond increases because its interest payments and fixed maturity price (known as par) are valuable under the effects of present value. For stocks, however, their present value declines. Though the discount rate (the desired rate of return to cover inflation) is low, deflation causes a decline in the nominal amount of future EPS.

The result is that stock prices fall and thus P/E declines.

Though P/E declines during deflation and inflation, the reasons are quite different. The P in P/E is the market’s determination of the present value of future earnings (or more accurately, the distributions from future earnings). The E in P/E relates to current earnings. Inflation and deflation do not affect the E in P/E; E is the current earnings amount rather than future earnings.

Inflation increases the future growth of E, but not by enough to overcome higher discounting; thus, the result is a lower P. Deflation drives the future trend for E negative, which despite the low discounting from deflation still results in lower P. In both instances, the lower values for P decrease P/E. Inflation’s impact on P/E results primarily from discounting and deflation’s impact on P/E results primarily from lower earnings.

The contrast of bonds and stocks during periods of inflation and deflation serves to dispel the myth that interest rates drive P/E. Though the association of P/E and long-term market interest rates is generally true, this mistaken association can lead to false conclusions under one of the scenarios. If the focus is only on the relationship between P/E and bond yields, then there will be a false outlook for deflation scenarios because high bond prices would diverge from falling stock prices.

The force of present value works on stocks just as it does on bonds. Since the inflation rate has been positive almost all of the time, analysts and pundits take the liberty of tying the common thread. As a result, the simplified relationship of bond yields and P/E is based upon the common relationship that bonds and stocks have to the inflation rate—but only when the inflation rate is positive. During periods when deflation poses a reasonable risk, the causes of divergence between stocks and bonds is especially important for understanding the impact of deflation on stock market returns.

In addition, there are implications for investment portfolios. Because bonds and stocks decline in value as inflation increases, bonds are poor diversifiers for stocks during inflation. During deflation, however, bond appreciation and yield can provide an offset to stock market losses.

There are several major points to recognise: First, rising inflation has an increasingly negative effect on bonds and stocks. Second, the negative inflation condition of deflation has a positive effect on bond prices and a negative effect on stock prices. Third, as deflation worsens, the increasing nominal decline in EPS drives P/E downward. Higher inflation and worsening deflation are increasingly negative to P/E. On the contrary, P/E peaks near the crossover point between deflation and inflation—when the inflation rate is low and stable (price stability). These points highlight the reason that inflation is Major Uncertainty #2 toward the probable outcomes for the stock market over this decade.

[Continuing from chapter 9] The most significant determinant of whether returns were above or below average, however, was the change in P/E. If P/E increased over the period, the effect is reflected as a green-bar extension to returns. If P/E declined, there is a red bar plunging into negative territory offsetting much or all of the return from earnings and dividends. The effect of the offset creates the troughs in figure 9.4.

Ironically, when earnings growth was strongest, returns were weak. The periods of the 1910s, ’40s, and ’70s included a number of years with relatively high inflation. Inflation adds to the nominal growth of earnings, thus reflecting a strong nominal contribution from EPS to total return. Nonetheless, the effect of a declining P/E in response to rising inflation more than offset the extra growth in earnings from inflation.

While the analysis is focused on rolling bar graphs, there is one additional version that can be used to gaze into the future. Figure 9.6 overlays the P/E ratio at the start of the 10-year periods with the rolling 10-year bar graph. The graph aligns the starting P/E with returns over the subsequent 10 years. The bars reflect annualized returns for the 10-year period. The line is the level of P/E at the start of the period represented by each bar. Since the starting P/E is a major driver of subsequent returns, the return bars move inversely to the P/E line. Further, this graph includes the starting P/E for the next 10 years; obviously, the bars will fill in over this decade. As a result, this figure provides an opportunity to anticipate the future. The seeds of destiny for 10-year returns, within a general range, are somewhat already sown.

The good news is that the peak in P/E at the start of the rolling decades is passing; therefore the return bars should begin to show positive results after the next period is added. There is probably little consolation in knowing that portfolios planted in the early 2000s will show little yield after a decade in the stock market. Even more disappointing, however, is that this decade (ending 2019) will also reflect poor trailing-decade returns. P/E is still not low enough to assure even average returns for the future from the current level of valuation.

**Figure 9.6. Using P/E to Gaze into the Future**

*Excerpted from Probable Outcomes: Secular Stock Market Insights by Ed Easterling, Copyright © 2011. Excerpted with permission.*

*Click here to visit Crestmont Research’s website. Probable Outcomes: Secular Stock Market Insights is available at Amazon.com.*