Back to the future

The Beijing Olympics opens with a dazzling spectacle. John McCain chooses Sarah Palin as his vice presidential running mate. Russia sends troops to South Ossetia, sparking international jitters. The S&P 500 index flirts with 1300.

That was all happening in August 2008, before Henry Paulson had ‘nationalised’ Fannie Mae and Freddie Mac, Lehman Brothers collapsed and the S&P 500 headed on a rocky route toward 666.

Over the past two weeks, the index has retraced its way back to those same pre-crisis levels, boosted by a showing of bumper profits from IBM, Apple, Alcoa and JP Morgan. It has tacked on 22% since last August, when Ben Bernanke announced plans for quantitative easing.

In theory, today’s price-to-earnings ratio of 16 reflects exactly the average since 1888. But it also depends how one calculates that PE figure.  Robert Shiller of Yale University prefers an inflation-adjusted price/earnings ratio (CAPE), which uses the same numerator price, but smoothes out the denominator earnings over 10 years, to adjust for the vicissitudes of the business cycle. Shiller’s CAPE formula is now screaming 24, which puts stocks far into overvaluation territory. (Although the CAPE has earned its prediction stripes on a long run basis, shorter term, prices can remain exuberant for months or years.) (article continues below)

Current equity prices reflect stellar corporate earnings, produced on the back of cost-cutting, anemic hiring and rock bottom interest rates. For earnings to retain their luster, employment must improve dramatically, or else profit margins are bound to stagnate. Looking out, according to analysts’ consensus, Thomson Reuters forecasts that earnings will grow 14.2% in 2011, with top line sales only advancing by 5.4%. Goldman Sachs, going out on a limb beyond the consensus, predicts an 8% growth in sales – and that hangs on a much healthier jobs market. Already, cost cutting has squeezed out potential margin compression, and rising commodity prices could further crimp results.

Analysts point to the 16 PE level, when they brush off concerns over European sovereign defaults, inflation dangers or rising energy costs. But the CAPE reminds that PE’s could actually be further out of whack than the ‘standard’ PE suggests.

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Vanessa Drucker is the American Editor of Fund Strategy, based in New York City. She has worked as a financial journalist for 20 years. In the 1980s, she practiced banking and securities law on Wall Street, and is the author of two business novels. Vanessa can be contacted at vanessa.drucker@centaur.co.uk.