Many often point to attractive valuation–as measured by a low price-earnings ratio–as a good reason to buy stocks.
However, the historical relationship between low P/E ratios and 12-month returns isn’t exactly linear.
Citigroup’s Tobias Levkovich provides the graphic below. It turns out that since 1940, the 12-month return for the S&P 500 higher during periods when the P/E ratio ranged from 12 to 16 than when it ranged from 8 to 12.
Obviously, there’s more to it than P/E’s. From Levkovich’s note:
One can also look at all kinds of history over the past 70 years and show via the P/E Bulls-Eye data (see Figure 9) that stock valuation is at a level that typically has provided for upside potential. Thus, we find the dislike for current market valuation as being more indicative of negative investor sentiment than a statistically-based objective perspective.
Admittedly, valuation alone cannot move share prices higher. Catalysts may need to involve some credible path towards fiscal resolution in Europe, improved political clarity in the US particularly with respect to the Presidential elections, Chinese hard landing fears subsiding and a greater belief that the US economy can decouple from Europe’s recession, to name a few possibilities. Nonetheless, we suspect that the faux valuation resistance will fade. As we have stressed in the past, we think the most crucial multiple enhancer will be some type of fiscal reform in the US that provides a modicum of confidence that a sovereign credit crisis will be avoided domestically and that the country’s long term growth prospects are still in place. Not surprisingly, fiscal reform is one of the six components of the secular Raging Bull thesis we outlined in a special report last month.
Photo: Citi Investment Research & Analysis