from this week’s “Sectors and Styles Strategy Report”*:
There has begun to be a fair amount of talk re stagflation and its
consequences, both economic and equity valuation. Should the experience in the
coming years resemble the stagflationary era of the 1970s, then P/E levels are
more than justified to crumble to single digit levels, as they did then.
Dismissing the stagflation threat entirely would be a
mistake. Yet, buying into the idea that a 1970s style stagflation environment
is in the current economic cards appears to be equally suspect as the world
economy are clearly changed considerably since then. There is, however, a
stagflationary scenario that does bear serious consideration – stagflation
In a stagflation lite environment, growth stalls like it did
in the 1970s but inflation rises at a much more modest degree. In such an
environment, the economic impact is obviously more muted, this thanks to a more
From a valuation perspective, P/Es, for example, would be
lower than they would be in otherwise less stressed times. But not quite to the
degree that they were in the 70s.
Investment Strategy Implications
The broad market investment implications of any version of
stagflation are rather straightforward – lower valuation levels. Any time
quality of earnings is affected, valuation levels must go down.
In a stagflation lite environment, an investor could kiss
the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year
US Treasury at Approx. 4%) goodbye. Nor would its historical level of 15 times
hold. However, only a stagflation period comparable to the 1970s would produce
single digit P/E levels as it did then. Hence the higher P/E probability in a
stagflation lite world would be somewhere around 12 times earnings.
If that were the case, then an $82 operating earnings (S&P 500) forecast would put the
fair value target for the S&P 500 at 984, a full 23% below current levels.
Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In
the process, the drop of 554 points from the high achieved in October 2007
would match against the 770 point increase from the low reached in October 2002
(to the high of October 2007) and, therefore, would produce a decline of
approximately 75% (from peak to trough). Such a drop would result in a slightly
greater than your standard major bull market correction of 2/3s.
Be it stagflation or stagflation lite, it does appear to be
touch premature to make such a call. Nevertheless, the market may be taking
some of this thinking into consideration, and so should we. More on this
prospect in the coming weeks.
To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.
To view this month's free sample "Sectors and Styles Strategy Report" sample, click here.
07-01-2008 6:08 AM
Vinny Catalano, CFA