@Revolution:Global Business News

New Economy, Leadership, Entrepreneurship, Management, Global Business

Valuation

Posted by iBlog on January 6, 2008

Talk about summertime blues. After peaking above 1,500 this July, the S&P 500 suffered an abrupt 10 percent correction before ending the month of August at 1,475. As of the publication of this article, the broad market has rebounded following interest rate cuts by the US Federal Reserve bank in mid-September. But stocks remain buffeted by a volatile credit market and by concerns that current high price levels might succumb to the same economic forces. Forces that caused the markets to plunge more than 40 percent in the three years after the last peak, in 2000.

As central bankers warily eye credit markets and ponder further interest rate cuts, no one can really anticipate what might happen next in a market wracked by volatility and skittish investors. Nonetheless, a comparison of the fundamentals underpinning the S&P’s recent performance and those at the time of the 2000 peak offers insights about the parallels and divergences between the two periods. These insights can give investors a better feel for where the market is now—and where it might head next.

First, the similarities. At one level, during both the run-up to the recent peak and the earlier dot-com market surge, most of the growth in market values was concentrated in a few sectors. Performance during the subsequent decline also varied by sector.

However, the peak in 2007 differed considerably from the one in 2000. During the 1990s investor euphoria and a highly speculative atmosphere overtook the market, raising P/E ratios to heights that made valuations unsustainable. In contrast, this year the market rode to its July peak on the back of exceptional corporate earnings, healthy GDP growth, a fast-paced M&A boom, and amazing consumer resilience despite a slump in the US housing market.

To get a better look at what exactly was driving the broad market during these periods, we analyzed two components of the market value of companies in the S&P 500—earnings and P/E ratios—assessing the performance of both over the past four decades at the market and the industry level.

As a first step we analyzed recent P/E levels. In an earlier article we described our simple P/E model,1 driven by a few fundamental factors that explain these ratios: long-term returns on capital, long-term real growth, the cost of capital, and expectations of inflation (Exhibit 1). Our model does a good job of explaining aggregate-market P/E ratios over the past 45 years—except during the speculative period around 2000. In that year overoptimism about the prospects of the technology, media, and telecom sectors and of megacompany stocks led the overall market P/E ratio to unsustainably high levels disconnected from the fundamental value creation potential of companies. The earlier article also shows that interest rates (and investors’ expectations of inflation) are inversely related to P/E ratios and have driven most of their fluctuations over the past 45 years.

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