So Long Price-Earnings, Hello Price-Expectations

Casino anyone? These are the consequences of boundless credit and QE 1234ever. This juicing of the asset markets with easy money has been going on for a couple of decades. Sooner or later we must pay the piper… I’m guessing the present culprits will be long gone by then and the citizens stuck with the bill.

From the WSJ:

Who cares about growth rates or profits as long as governments and central banks goose the markets?


At the end of last week, major equity indexes including the S&P 500, the Stoxx Europe 600 and the MSCI Emerging Markets were up by about 15% from their early June lows, while the Dow Jones Industrial Average was up around 12.5%. Certain European bourses did even better, such as Spain’s IBEX 35, which surged more than 30%.

Market participants had been eagerly expecting and pricing in some positive developments, and they ended up getting everything they had hoped for. Between Aug. 31 and Sept. 12, the Federal Reserve announced it would engage in yet another round of quantitative easing; the European Central Bank said it would implement a new bond-buying program to support troubled EU countries; and the final legal hurdle to Germany’s ratification of the European Stability Mechanism, the euro zone’s permanent bailout fund, was cleared.

But this avalanche of good news was all about monetary action or political developments. It had nothing to do with the actual state of the global economy, which, according to a variety of indicators, remains worrisome.

The United States continues to grow at an abnormally slow pace, as shown by the latest estimate of second-quarter GDP, which was revised from a meager 1.7% on an annual basis to an even weaker 1.3%. The euro zone is stuck in no-growth territory as it struggles with its debt crisis. As for China, the world’s main growth engine, no one knows exactly how hard a landing it is currently experiencing—but its most recent manufacturing data signal a greater slowdown than previously anticipated.

None of this seemed to have had any effect, though, on global markets in recent months. It was as if traders world-wide had decided to ignore hard economic facts and focus exclusively on actions taken by governments and central banks to prevent the current crisis from getting even uglier than it already is.

In mid-September, soon after this chain of market-friendly events came to an end, the rally began to lose momentum and eventually stalled. Fortunately, Spain’s expected decision to request a full-fledged bailout (on top of the billions it already received to shore up its wobbly banking sector) quickly emerged as a new reason for hope.

Yes, as bizarre as it may seem, the thing that every bull is looking forward to—the announcement that could revive the rally and take equity markets up by another 3%, 5% or even 10%—is the official acknowledgment by the euro zone’s fourth-largest economy that it can no longer cope with its massive debt. As a result, every single move in the continuing poker game between Spanish Prime Minister Mariano Rajoy and European Central Bank President Mario Draghi is being meticulously analyzed.

Investors have always been in the business of anticipating, if not predicting, the future, and there is nothing wrong with this. However, in doing so, they would normally look at “real” economic indicators, such as GDP growth, corporate revenues, earnings outlooks and price-to-earnings ratios. They also knew that trying to figure out what was coming next did not give them a license to totally ignore current realities.

The 2008 global financial crisis and continuing debt crisis in Europe have changed that: The main thing that now seems to move markets—on the upside and on the downside—is monetary and political intervention (or lack of intervention, for that matter).

With traders constantly expecting the next summit, election result, central-bank decision or court ruling, the traditional price-to-earnings ratio has given way to a new indicator, which one could call the price-to-expectations ratio.

No need to worry about sluggish (or negative) growth, high unemployment, deteriorating corporate prospects and ever-rising public debts—as long as the price-to-expectations ratio remains under control, markets have room for appreciation.

The beauty of this new P-E number is that it never gets too high, because as asset prices rise, markets can always raise their expectations accordingly. Any sensible observer would have a hard time doing the same.

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