[An excerpt from Gary Shilling’s Insight via Pragmatic Capitalism.]
Low and zero interest rates also influence investors’ views of the values of stocks. The theory says that lower interest reduces the discounting rate that converts future earnings into current stock values and thereby raises their present worth. Also, lower interest rates are supposed to raise price-earnings ratios by making stocks cheaper relative to bonds.
In any event, stock bulls and many equity analysts believe that corporate profits growth has been so robust that even considerable economic weakness will not depress stock prices significantly from current levels. And, as usual, equity analysts see robust company-by-company earnings for 2012, with a gain of 14.4% for this year’s estimate for S&P 500 operating earnings. More sober, top-down strategists still look for a rise of 5.9%. Those numbers put the S&P 500 currently selling at 10.3 and 11.4 times next year’s earnings, respectively—reasonably cheap relative to the 19.0 average P/E since 1960.
But only two quarters of 2011 earnings are recorded so far, and estimates for the second half may prove to be far too rosy, jeopardizing the bottom-up analysts’ forecast of a 17.8% gain for 2011 and 14.8% for the top-down strategists. Similarly, their forecasts for 2012 may prove unrealistically optimistic.
We’ve never understood the concept of P/Es that compare current prices with next year’s earnings forecast. It strikes us somehow as double- discounting, of forecasting future earnings and then treating those forecasts as certain enough to determine the current values of stocks. This approach works in long bull markets with steady earnings gains, but come a cropper when the bear visits.
Our friend, Yale Professor Robert Shiller, avoids this problem as well as the volatility of recent corporate earnings by calculating the S&P 500 P/E based on earnings over the last 10 years (Chart 7). His average since 1960 is 19.4, implying that stocks in July when his P/E was 22.9 were 18% overvalued. More important, in reaching that long-term average P/ E of 19.4, stocks spend about half the time above it and half below. Most of the last decade has been above the average line, so there may be some catching up on the down side. This fits our view of a decade or so of deleveraging and a secular bear market that started in 2000.
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