Tuesday, October 16, 2007

Two Sides to the P/E Ratio

People wonder how the stock market can do so well, when the housing market is doing so horribly. And the reason is simple; corporate earnings are doing great.

Corporate earnings as a percent of GDP have never been higher in recorded history.

These high profits have driven the P/E ratio down from their stratospheric levels to more sane ones that are more or less in line with historic averages.

However, while the majority of people focus on stock prices as the primary measure by which to determine whether markets are over valued, they forget P/E ratios are a double edged sword forgetting that earnings can also sway dramatically, quickly eroding price support to stocks. This is the true risk to the stock markets.

For while the housing market has yet to "infect" the rest of the economy, it will do its damnedest to. First to fall will be the financial sector. This is evidenced by the spate of earnings and write off troubles various financial institutions are having. And we're not talking the schleppy, b-movie firms. We're talking top shelf firms; Bear Sterns, UBS, even Merrill Lynch posted it's first loss since 2000. Nor are we talking US firms. Foreign firms were fed a line of bull when they bought up 17% of our worthless MBS's and now they're suffering the consequences.

The question is whether it will spill into the non-financial sector and drive down overall earnings thereby triggering a stock market crash. And while I think that is a very real possibility, allow me to point out a silver lining that might just save us.

In a weird and perverted twist of economics, Americans' utter disdain for any measure of fiscal discipline may save them. For in spending more than they make, they've essentially tanked the US dollar against practically all other currencies.

However, corporate America has been wise, investing more than most other countries overseas, and therefore have diversified themselves into other markets, inoculating themselves against a downfall here. Plus, while on the domestic front things may collapse, profits made in foreign countries, denominated in foreign currencies may bolster profits here as they're remitted back home and converted into dollars. Additionally, a weak dollar may boost foreign demand for US assets and firms, such as China's sovereign wealth fund, putting upward pressure on stock prices.

Of course I doubt a favorable exchange rate and increased foreign demand for US stocks will solely prevent the stock market from at least some kind of correction, but it may soften the blow.

1 comment:

Anonymous said...

I'm wondering if the increased foreign investment will be enough to cover the downward pressure that will come as Boomers sell off their stocks to finance their retirement. Unfortunately, that's a quantitative question that I don't really have the resources to answer myself. I suppose if one knew, they could become rather wealthy with that knowledge.