pe-future on the horizon doug short

7/31/2019 PE-Future on the Horizon Doug Short

1/12

P/E: Future on the HorizonBy Ed Easterling

May 3, 2011

Advisor Perspectives welcomes guest contributions. The views presented here do notnecessarily represent those of Advisor Perspectives.

This article original appeared on Doug Shorts site, www.dshort.com. Itis a must-read follow-on to a two-part series by Ed Easterling. Itdiscusses the ability of the Crestmont methodology for P/E and EPS,unlike other methods, to provide forward-looking insights for investors.Here are links to the previous articles: P/E: So Many Choices, Part I

andPart II.

Ed's books, Unexpected ReturnsandProbable Outcomes, haveDougs unqualified endorsement for anyone trying to understand thecomplex and often puzzling relationship between the economy and themarket.

When you embark on a trip toward a desired destination, it is importantto know your starting point and the path that you will take. For everyinvestor, the destination is financial success. Wouldn't it be helpful to have a financial

planning GPS, especially one with updates about market corrections to help you detouraround the snarl? The reality, however, is that no such magic device exists and investmentsuccess requires old fashioned discipline and judgment.

Discipline starts with an assessment of the environment and a map of the journey.Ptolemy, a famous cartographer and astronomer almost 2000 years ago, drew horizontaland vertical lines around the globe to enable seafarers to navigate unknown waters usingtools of the time. He created the parameters and framework that enabled ship captains tosee their futures on the horizon. They no longer were destined to follow a path of hope;they could have strategies that empowered direction with insight.

The principles

Conventional wisdom holds that long-term forecasts of the stock market must beimpossible because "even its short-term predictability is challenging." If you can'treasonably know what will happen next week or next year, how on earth are you to knowwhat will happen next decade?

Copyright 2011, Advisor Perspectives, Inc. All rights reserved.
http://www.dshort.com/http://dshort.com/articles/Easterling/PE-So-Many-Choices-01.htmlhttp://dshort.com/articles/Easterling/PE-So-Many-Choices-02.htmlhttp://dshort.com/articles/Easterling/PE-So-Many-Choices-02.htmlhttp://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.amazon.com/dp/1879384825/ref=as_li_tf_til?tag=advisoperspe-20&camp=14573&creative=327641&linkCode=as1&creativeASIN=1879384825&adid=0ANFKTGTM4XFR5X44PZB&http://dshort.com/articles/Easterling/PE-So-Many-Choices-01.htmlhttp://dshort.com/articles/Easterling/PE-So-Many-Choices-02.htmlhttp://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.dshort.com/


2/12

Well, there's a simple lesson from the forest.There are many factors that impact the growth

of trees each year: rain, sun, temperature, anda host of other conditions. Ask any forester; allof those conditions make it impossible toaccurately predict tree growth for any givenyear. Yet ask that same forester about thenext decade and she will reach for thehistorical tables. They provide standards fortree growth over long-term decades. When atree is ultimately cut and its rings aremeasured, the year-to-year variances averageout to prove the reliability of the historicaltables.

But every tree does not grow at the same rate under all conditions. The universal"average" is a fallacy. For example, trees of the same species grow at slower rates whenconfronted with altitude, colder temperatures, and reduced rainfall. Likewise for the stockmarket, it does not generate the mythical 10% average return under all conditions. Thereare fundamental principles and factors that cause stock market returns.

Stocks are instruments of ownership in companies that generate profits over time. Stocksare financial assets that have value because of future cash flows in the form of dividendsand earnings. Today's value for a stock, and the stock market overall, is driven by futureearnings growth and market rates of return.

It's almost that simple: if you can assess the likely growth rate for earnings and have anestimate for market rates of return, then forecasting the future of stock market returns isclearly on the horizon.

EPS growth

Earnings growth is driven by economic growth. Both factors have their own cycle. Theeconomy, as measured by gross domestic product ("GDP"), fluctuates every decade or sothrough expansions and recessions. Earnings growth, almost like a moon around a planet,fluctuates around the economy's course. Profit margins expand, bringing the responses ofcompetition and production, only to be followed by excesses in both that contract marginsto rebalance conditions. But balance rarely occurs. It remains an occasional crossing pointfor ever repeating cycles. That's why investors need tools to assess the overall trend, lestthey be destined to zig and zag aimlessly without a compass to help them focus on thehorizon.

Therefore, to estimate future stock market returns, investors need measures of earningsgrowth and market valuation levels (as measured by the price-to-earnings ratio, "P/E").



3/12

The Crestmont methodology for earnings per share ("EPS") and P/E provides a tool notonly to evaluate historical trends and results, but also to assess the course of the market

and its future on the horizon. Crestmont's EPS and P/E are based upon regressions andrelationships between historical EPS and GDP. Thus, with future estimates of GDP,Crestmont's methodology provides forecasts of EPS.

[dshort note: for more details, see P/E: So Many Choices, Part I posted on April 26.]

For example, when the methodology was discussed in Unexpected Returns (written in2004 and published in 2005), Figure 7.9 provided a prediction for EPS through 2011(presented as Chart 1 below). It was based upon a forecast for GDP that extended then-recent history into the future.

Chart 1. Figure 7.9 from Unexpected Returns

Note the upper-right graph; it provides an estimate for EPS from 2004 through 2011. It'sironic that we can now look back from the final year of a seven year old forecast to assessits credibility.

By 2006, the Wall Street pundits were laughing at the laggard line in Figure 7.9 as S&P500 companies posted profits of more than $81 per share (compared to $56 on the chart).

http://dshort.com/articles/Easterling/PE-So-Many-Choices-01.htmlhttp://dshort.com/articles/Easterling/PE-So-Many-Choices-01.html


4/12

Their forecasts expected $100 per share within two years. It was as though thegravitational force of the business cycle had been conquered. The pundits led investors to

see the Crestmont forecast as the old blue earth from outer space orbit, a remnant so faraway that it was no longer relevant.

Two years later, the view for the trend line forecast had shifted this time the punditslooked upward to see it (like the diver reaching for the water's surface). Chart 2 (below)presents the forecast chart from Unexpected Returns with an overlay of actual historythrough 2010 and the current forecast for 2011.

The pink line is the published forecast from 2004; the green line reflects what actuallyhappened. It is very typical that the actual course of EPS, based upon many decades ofhistory, zigs and zags around the natural course. Once again today the view isshifting and hope springs eternal on Wall Street. Reported EPS has surged past the basetrend line ... and the current forecast by S&P calls for $99 in 2012. Maybe this time will bedifferent (but I wouldn't bet on it!).

Chart 2. Updated Excerpt from Figure 7.9 in Unexpected Returns

Subsequent to 2004, the forecast for future Crestmont EPS downshifted slightly (as did thetrend line for some of the recent years). The earlier forecast for EPS was based upon



5/12

historically average GDP growth. But the economy in the 2000s fell short, even before therecession of 2008. As a result, the current outlook is a combination of continuing the slow-

growth trend and restoring the historical average. That's why economic growth is MajorUncertainty #1 in Probable Outcomes.

Nonetheless, the range in Chart 3 fairly well frames the baseline course for the rest of thisdecade. The actual path, however, likely will stray wildly; but, the natural line that drivesmarket valuation tracks within the channel.

Chart 3. Figure 12.1 from Probable Outcomes

The shaded triangle reflects the results under various assumptions. The upper boundaryline represents the most optimistic assumption for nominal EPS growth. This includes 4%real economic growth and rising inflation. The lower boundary represents the leastfavorable assumptions: 2% real economic growth and deflation. The most likely result willoccur within the field. Two points are included on the right side for 2009. The first relates tohistorical growth and average inflation; the second is average growth and low inflation.



6/12

Most importantly, the shaded "field" is where the earnings game will be played. It canserve as a compass for EPS to keep in perspective the normal business cycle as well as

the over-extrapolated forecasts from manic analysts. For example, as of today, currentlyreported EPS and forecasts for the next two years exceed the top boundary. Profit marginsare high. Within the next few years, the power of the business cycle will realign EPSgrowth back to its natural course. Don't be surprised, by the way, if reported EPS dipsbelow the lower boundary the magnitude of swings in EPS from the business cycle aredramatic. That is why a normalized measure for EPS, especially one that is forwardlooking, is so important to investors.

P/E multiple

The price-to-earnings ratio ("P/E") is the major multiplier of stock market returns over time.Sometimes, however, the multiplication is a fraction rather than a whole number. WhenP/E rises over time, the increase in the multiple exponentially drives returns. This createsperiods of above-average returns the secular bull markets. Conversely, a decline in P/Eover time offsets earnings growth and leads to periods of below-average returns thesecular bear markets. P/E, therefore, is a major factor for the ultimate course of the stockmarket.

P/E does not follow a random course; it is driven by the trend and level of the inflation rate.Chart 4 reflects the relationship of P/E and inflation. Periods of higher inflation or deflationdrive P/E lower and periods of price stability (i.e., low and stable inflation) drive P/E higher.

[dshort note: for more details, see P/E: So Many Choices, Part II posted on April 27.]

http://dshort.com/articles/Easterling/PE-So-Many-Choices-02.htmlhttp://dshort.com/articles/Easterling/PE-So-Many-Choices-02.html


7/12

Chart 4. The Y Curve Effect

This is important because it provides the framework to understand that P/E is not arandom variable, but rather one that is subject to fundamental forces and principles. Thechange in P/E over time is not only one of the three components of stock market returns(dividends and earnings growth are the other two), it has the most significant effect on thevariability of returns over decade-long periods.

P/E is not only driven by inflation, it is also driven by the long-term growth rate of earnings.

Earnings growth over the long-term is driven by economic growth. Historically, realeconomic growth has been relatively constant across the decades averaging near 3%. Asa result, P/E progressed from highs to lows based upon the inflation rate.

The range of highs and lows, from just over 20 to just under 10, was determined by the 3%economic growth constant. Had economic growth been lower, then the range and averageP/E would have been lower. This paragraph cannot be emphasized enough theimplication is a game changer for P/E if the long-term future reflects lower economicgrowth.



8/12

The 2000s brought a period of economic surprise. The growth rate was not 3%.

Conventional wisdom, based upon excessive leverage and unsurpassed Americanconsumerism, holds that economic growth surged forward unsustainably. Supposedly, theU.S. is now expected to atone for that binge with a decade or more of slower growth.

But, real GDP growth in the 2000s was only 1.8%. Even before the 2008 recession,cumulative GDP was chugging along at 2.6% annually and did not exceed 2.7% annuallyduring that decade. Therefore, and this is a major unknown, the economy may bepositioned for a restorative above-average decade ... or it could have downshifted to a newlower level. This emphasizes why future economic growth is Major Uncertainty #1 inProbable Outcomes.

A 4% decade would simply get the economy back on track for its 3% trek. If the neweconomy provides only 2% growth, however, the impact is a downshift in the range forP/E. Note in Chart 5 that the inflation rate will continue to determine the position within therange, but the growth rate determines the level of lows and highs.



9/12

Chart 5. P/E Drivers: The Inflation Rate & The Growth Rate

Outcomes on the horizon

Most people expect P/E to measure current valuation and to show historical patterns. Butmore features are available from some versions of P/E. The methodology behind theCrestmont P/E enables investors to anticipate the future. It may not precisely predict themarket ten years away, but it frames within a relatively tight range the likely outcome. Onecomponent from determining the Crestmont P/E is a means to assess the future trend linefor EPS using estimates of future economic growth (GDP).

GDP growth over this decade, albeit somewhat uncertain, is highly likely to average withina fairly narrow range between 2% and 4% annually. The higher value of 4% reflects growthreverting to its long-term average. The lower value of 2% indicates significant drags on theeconomy. With population growth near 1%, even just a little productivity drives economicgrowth to 2%. Most pessimists predict between 2% and 2.5%. Most optimists hope for3.5% or slightly higher. If you poll your favorite economists, the high odds-on range foraverage economic growth will almost certainly be 2% to 4%.



10/12

The other major factor for estimating stock market returns is a reasonable estimate for P/E

in the future. From earlier principles, the primary driver for P/E is the inflation rate.Although the range of outlooks for inflation can be quite broad, there are three primarycategories of outlooks. The first is higher inflation, the second is price stability (i.e., lowinflation), and the third is deflation. For each category, there is an estimated P/E using TheY Curve and historical data.

Chart 6. Figure 12.1 from Probable Outcomes

For ease of reference, Chart 6 repeats the earlier Chart 3 (which presents the range ofEPS based upon various scenarios for GDP growth). Therefore, with three scenarios foreconomic growth and three scenarios for the inflation rate, there are nine compositescenarios for stock market outcomes. When the scenarios for P/E (from Chart 5) areapplied to the scenarios for EPS (in Chart 6), and dividend yields are added to the results,the result is the Probable Outcomes Matrix in Chart 7!



11/12

Chart 7. Probable Outcomes Matrix: Real & Nominal Returns

This identifies the two major factors that drive stock market returns over the long-term.Certainly there are numerous other factors that impact these two, but the ultimate value ofthe stock market (i.e., the value of its cash flows), is determined by the growth in cash

flows and the discount rate applied to those cash flows. The cash flows of companiesemanate from earnings, which for the stock market overall is driven by economic growth.The discount rate, as reflected in P/E, is driven by the inflation rate.

These scenarios are useful in several ways. First, they frame the range of probableoutcomes. That helps investors to structure their portfolios and financial plans. Althoughthe scenarios reflect what is likely, they also tell us what isn't likely. For example, anaverage or better stock market return (i.e., the famous 10%) is highly unlikely for thisdecade (without another bubble of course). As investors consider various investments fordiversification, alternatives with solid 6%, 7%, 8%, etc. return profiles can be quiteattractive.

Some investors are afraid to miss the next secular bull market (longing for the 1980s and'90s again) and thus often shun such investments. They see them as anchors thatcompromise stock market portfolios. Yet in secular bear market periods, like today, those"anchors" may turn out to be engines!

With the right tools and reasonable assumptions, the future of stock market returns is onthe horizon and visible to investors. There's no reason that anyone should look back in2019 and say "who knew?" as savings underperform or dwindle. Institutional investors,



12/12

especially, risk great burden if they rely upon unrealistic assumptions for returns. Earlyrecognition, whether individuals or institutions, can enable smaller solutions in advance

rather than major reactions in crisis.

Copyright 2011, Crestmont Research (www.CrestmontResearch.com)

Ed Easterling is the author of recently-releasedProbable Outcomes: Secular Stock MarketInsights and award-winningUnexpected Returns: Understanding Secular Stock MarketCycles. Further, he is President of an investment management and research firm, and aSenior Fellow with the Alternative Investment Center at SMU's Cox School of Businesswhere he previously served on the adjunct faculty and taught the course on alternativeinvestments and hedge funds for MBA students. Mr. Easterling publishes provocativeresearch and graphical analyses on the financial markets atwww.CrestmontResearch.com.

www.advisorperspectives.comFor a free subscription to the Advisor Perspectives newsletter, visit:http://www.advisorperspectives.com/subscribers/subscribe.php

http://www.crestmontresearch.com/http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.crestmontresearch.com/http://www.advisorperspectives.com/http://www.advisorperspectives.com/subscribers/subscribe.phphttp://www.crestmontresearch.com/http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384825/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.amazon.com/exec/obidos/ASIN/1879384620/ref=nosim/wwwcrestmontr-20http://www.crestmontresearch.com/http://www.advisorperspectives.com/http://www.advisorperspectives.com/subscribers/subscribe.php

pe-future on the horizon doug short

Documents