INVESTMENT & ECONOMIC ANALYSIS
SOCIAL TOPICS: INVESTMENT & ECONOMIC ANALYSIS
Return to Judgment II
Published, July 2000
A year ago we wrote here that the outstanding returns in some index-like social portfolios had been produced by large price increases in a relatively small number of big capitalization stocks, mostly in technology, while much of the rest of the market had made little return. This had left many portfolios, and to an extent the market as a whole, concentrated in a few, expensive stocks. The result was an unusually high level of investment risk in some social portfolios.
During the second half of last year this concentration intensified. Valuations, in terms of price/earnings ratios (P/Es), rose even higher for the most expensive stocks. Meanwhile, prices for stocks with lower P/Es actually declined. Although the S&P 500 returned 21 percent in 1999, more stocks declined than increased. The 100 stocks with the highest P/Es at the beginning of 1999 had, by year-end, an average return of over 30 percent and a P/E of 61. The average for the 100 lowest P/E stocks was just 9, producing the widest P/E spread on record in the S&P 500.
What does this wide spread tell us? In theory, investors buy stocks with high P/Es only if they expect earnings to grow rapidly. The opposite is true of stocks with low P/Es. A wide dispersion of P/Es indicates large differences in expected growth among stocks.
An important feature of this market is that the very high P/E stocks are not limited to small growth stocks. Indeed, the 100 highest P/E stocks, representing the so-called new economy companies, make up about half the market value of the S&P 500. This is important because of the inherent relationship between the stock market and the economy.
Economy-wide growth places a constraint on the overall earnings growth of the market. If the economy continues strongly, with say 4 percent real growth per year, and inflation is 2 percent, overall growth will be about 6 percent. Profits can only grow as fast as overall GDP unless they claim a greater share of GDP. Since profits’ share of GDP is already close to its historical high, it is unlikely profits can grow much faster.
We therefore believe the growth rates implied by the high P/E valuation of the very largest stocks are unrealistic. The earnings growth required to support the pricing of the group of 100 stocks with the highest P/E ratios in the S&P 500 is about 30 percent per year for five years. Given the limited overall growth in the economy, this implies that the earnings of the remaining 400 stocks in the market index will decline by 6 percent per year from the current level over the same five year period. (Contact us for background assumptions and calculations.)
This seems implausible because the “old economy” companies in the bottom 400, whose earnings are expected to shrink rather than grow, are the very companies to whom the high P/E companies would have to sell their products in order to achieve their high expected earnings growth rates! Corporate profits do not grow in a vacuum. The broad economy serves as a backdrop against which different industry groups grow at differing rates.
Thus growth expectations for the new economy are unlikely to be met and prices will likely move downward to reflect new, more sober projections for the largest stocks. Technology heavy social portfolios and market baskets could be particularly vulnerable to this painful adjustment. Conversely, the bleak earnings picture of the bottom 400 is likely to improve, creating opportunities for better returns there. Such a period of change calls for a return to judgment as the market retraces its steps from the extreme and unsustainable valuation gaps of the last year. — Bob Lincoln
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