Crestmont Quarterly Review

October 13th, 2012
in contributors

CURRENT STATUS (Third Quarter 2012)

by Ed Easterling, Crestmont Research

The stock market rallied over the past quarter, increasing P/E further into the range of “fairly-valued.” P/E has returned to the same level as the end of probable-outcomes-bookSMALLthe first quarter, which is the highest P/E since mid-2008. By historical standards, the higher levels of P/E in 2007 (~25x) were near the upper limit of “fairly-valued.” One implication could be that the current level of P/E has room to grow. Yet for investors that now foresee a greater risk of slower economic growth and/or a higher inflation rate or deflation in the future, the upper bound for P/E fair-value would be much lower than historically warranted. Further, note that the reported P/E increased this quarter not only due to the market rally, but also as a result of a decline in earnings. The reported P/E remains distorted below the normalized P/E due to currently high and unsustainable profit margins. The trend in earnings should be watched closely and investors should remain cognizant of the risks confronting an increasingly vulnerable market.

Follow up:

Click on table for larger image.


The P/E ratio can be a good measure of the level of stock market valuation when properly calculated and used. In effect, P/E represents the number of years worth of earnings that investors are willing to pay for stocks. Although we will discuss later the business cycle and its periodic distortion of “reported” P/Es, most references to P/Es in this report will relate to the normalized P/E that has been adjusted for those periodic distortions.

Stocks are financial assets which provide a return through dividends and price appreciation. Both dividends and price appreciation are generally driven by increases in earnings. Despite the hope of some pundits, earnings tend to increase at a similar rate to economic growth over time.

Historically (and based upon well-accepted financial and economic principles), the valuation level of the stock market has cycled from levels below 10 times earnings to levels above 20 times earnings. Except for bubble periods, the P/E tends to peak near 25 (the fundamental limitations to P/E are discussed in chapter 8 of Unexpected Returns). Figure 1 presents the historical values for all three versions of the P/E discussed in this report.

Figure 1. P/E Ratio: 1900-3Q2012E (EPS estimate from S&P)

Click on graph for larger image.

What drives the P/E cycle? The answer is the inflation rate—the loss of purchasing power of money and capital. During periods of higher inflation, investors want a higher rate of return to compensate for inflation. To get a higher rate of return from stocks, investors pay a lower price for the future earnings (i.e. lower P/Es). Therefore, higher inflation leads to lower P/Es and declining inflation leads to higher P/Es.

The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings (the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.

Secular market cycles are not driven by time, but rather they are dependent upon distance.

Therefore, for this discussion, assume that there are three basic scenarios for inflation: rising, low, and deflation. As discussed above, rising inflation or deflation causes the P/E ratio to decline over an extended period which in turn creates a secular bear market. From periods of higher inflation or deflation, the return of inflation to a lower level causes the P/E ratio to increase over an extended period thereby creating a secular bull market.

Secular bull markets can only occur when P/E ratios get low enough to then double or triple as inflation returns to a low level. As a result, secular market cycles are not driven by time, but rather they are dependent upon distance—as measured by the decline in P/E to a low enough level to then enable a significant increase.


The current P/E is 20.8—well above the historical market average and well into the range that would be expected in a low inflation environment (assuming historically-average economic growth). BUT, secular markets are driven by longer-term annual trends rather than momentary market disruptions.

The secular analysis for each year relates to the average index across the year; so for each year, the price (P) in P/E (price/earnings ratio) is the average index for all days of the year. The stock market has recovered most of its declines from late 2008 and early 2009; therefore, it’s now fairly clear that the period in late 2008 and early 2009 was just a cyclical (short-term) bear market blip within a longer secular bear market. Of course, that makes the last four years a typical cyclical bull market inside a secular bear market (it has happened many times before).

If the stock market does not recover further or cannot sustain the recovery gains from the past four years due to significant inflation or deflation, the normalized P/E over the next few years will likely decline below the historical average and the foundation for a secular bull market would begin to be laid.

We’re in a period with many daily (often hourly) points that represent pixels in the market’s picture. The short-run trends (the cyclical cycles) of the market are hard to predict. Without extraordinary powers of clairvoyance, the best plan is a diversified, non-correlated portfolio with a few engines to counterbalance the weaker components of the portfolio.


As described further in “The Truth About P/Es” in the Stock Market section at, P/E ratios can be based upon (a) trailing earnings or forecast earnings, (b) net earnings or operating earnings, and (c) reported earnings or business cycle-adjusted earnings.

(a) The historical average for the normalized P/E is 16.3 based upon reported ten-year trailing real earnings (i.e., the method popularized by Robert Shiller at Yale). The ultra-high P/Es of the late 1990s and early 2000s were high enough and lasted long enough to significantly distort what we now know to be the average P/E. If those years are excluded, the normalized P/E is almost one multiple point lower (i.e., approx.. 15.5). Further, if forecast earnings is used, the average normalized P/E would be reduced by approximately one multiple point to 14.5. Note that the average reported P/E from 1900 to 2011, unadjusted for the business cycle and adjusted for the late 1990s bubble, is 14.

(b) Substituting operating earnings for net earnings would further reduce the normalized average P/E by almost three points to 11.5.

(c) Although the effect of the business cycle is muted in longer-term averages, the currently-reported P/E varies significantly due to the business cycle (more later).

It is important to ensure relevant comparisons—that is, P/Es that are based upon trailing reported net earnings should only be compared to the historical average of 14. When ten years of real net earnings are used in P/E (i.e., Shiller P/E10), the relevant average is 15.5.

Too often, writers and analysts compare a P/E that is based upon forecast operating earnings to the average for trailing reported net earnings. Although long-term forward operating earnings data is not available, the appropriate P/E for that comparison would be closer to 11.

Yet the most significant distortion from quarter-to-quarter or year-to-year is due to the earnings cycle, or as some refer to it, the business cycle.


As described further in “Beyond The Horizon: Redux 2011”, “Back To The Horizon”, and “Beyond The Horizon” in the Stock Market section at (and in more detail in chapters 5 & 7 of Probable Outcomes: Secular Stock Market Insights), corporate earnings progresses through periods of expansion that generally last two to five years followed by contractions of one to two years. The result of these business cycles is that earnings revolves around a baseline relationship to the overall economy. Keep in mind that the business cycle is distinct from the economic cycle of expansions and recessions.

Figure 2. EPS: S&P 500 Companies (1950 to 2012E)

Click on graph for larger image.

For example, looking back over the past six decades, Figure 2 presents the annual change in earnings historically reported by the S&P 500 companies and forecasted by Standard & Poors. This graph highlights the surge and decline cycle of earnings growth that is driven by the business cycle.
When the reported amount of earnings is viewed on a graph, the result is a generally upward sloping cycle of earnings growth. Since earnings (“E”) grows in a relatively close relationship to economic growth (GDP) over time, there is a longer-term earnings baseline (as discussed in chapter 7 of Unexpected Returns) that reflects the business cycle-adjusted relationship of earnings to economic growth (GDP). Figure 3 presents actually reported E for the S&P 500 over the past four decades compared to the longer-term baseline.

Figure 3. EPS: Reported vs. Trend Baseline (1970 to 2013E)

Click on graph for larger image.

Why does this matter? Because if you only look at the P/E ratio reported for any quarter or year, the ratio (with such a volatile “E” as the denominator) will be quite distorted during peaks and troughs when compared to the more stable long-term average. About every five years or so, the reported P/E will reflect the opposite signal rather than a more rational view of P/E valuations. For example, the reported value for P/E in early 2003 reflected a fairly high value of 32 just as the S&P 500 Index had plunged to 800 (E had cycled to a trough of $25 per share). A P/E of 32 generally screams “sell” to most investment professionals; yet, in early 2003, that was a false signal! A more rational view using one of the business cycle-adjusted methods reflected a more modest 18. In a relatively low inflation and low interest rate environment, the scream should have been “Buy”…

Several years later, in 2006 (after an unusually-strong run in earnings growth), E peaked at $82 per share as the S&P 500 Index was hesitating at 1500. Most market pundits were recommending a strong “buy” due to a calculated P/E of only 17. Yet, using the rational business cycle-adjusted methodologies, the true message was “STOP”—P/Es were saying sell, with P/E more than 25.

Well the pundits were actually (sort of) right—P/Es did expand… Yet it was due to (what should have been expected) the normal down-cycle in E rather than the pundit-promoted increase in the stock market. So when investors’ stock market accounts were down almost 50%, they were handed explanations that the earnings decline was unexpected and the fault of the financial sector…

Many of the same pundits are bewildered by current market conditions and unsure about the future of E. Maybe this time will actually be different…or maybe not…

As for the market and P/E, it’s understandable that conservative investors and market spectators have watched the past few years with awe. Even so, the current momentum remains upward. Nonetheless, it is important to remain aware that typical market volatility makes it also likely that the market will experience significant short-term swings.


To adjust for the variability of earnings across business cycles, a rational methodology is needed to reduce distortions and provide a normalized reading about the long-term level and trend in earnings. The most recognized methodology is the one popularized by Robert Shiller (Yale) in Irrational Exuberance and on his website. To smooth the ups and downs in earnings, his methodology creates an average of the reported earnings for the past ten years. To eliminate the effect of inflation, all earnings values are adjusted-forward and increased by the impact of inflation. The result is a ten-year average for E. Using the current stock market index value, we have a more rational view of the current P/E valuation of the stock market.

For historical values, whether it relates to a month or a year in the past, Shiller also adjusts the stock index value by averaging the closing price for each day during the period. The stock index adjustment reduces historical distortions caused by significant intra-period swings by the market.

Crestmont has developed a complementary methodology—one that is fundamentally-based—that produces similar results, yet also provides forward-looking insights. The approach is explained further in Chapter 7 of Unexpected Returns, yet in summary, it uses the close and fundamental (not coincidental) relationship between earnings per share (“E”) and gross domestic product (GDP) to adjust for the business cycles. The baseline E for each period essentially is based upon mid-point values for E across the business cycle—peak and trough periods of actual earnings reports are adjusted back to the underlying trend line to reduce the intra-cycle distortions.

Figure 4. P/E Ratio Methodologies: Crestmont vs. Shiller

Click on graph for larger image.

The historical relationship between Crestmont and Shiller is similar, as reflected in Figure 4, yet the Crestmont approach provides an estimate of the expected level of E based upon future economic growth (which has been fairly consistent over time). Also, by comparing reported E to baseline E, analysts and investors have a better understanding of the current position in the business cycle and magnitude of divergence above or below the long-term trend.


Secular bull markets can only occur when P/E ratios get low enough (due to high inflation or significant deflation) to then double or triple as inflation returns to a low level. As a result, secular market cycles are not driven by time, but rather they are dependent upon distance—as measured by the decline in P/E to a low enough level to then enable it to have a significant increase.

The table that follows in Figure 5 provides a representation of the ‘distance’ that would be required to reposition for a secular bull market. The scenario presents the typical historical starting point for secular bulls (i.e. P/Es below 10).

Note that this analysis does not include the dynamic of ‘time’. As we continue forward in time, the normalized level of earnings (“E”) will increase and naturally close the gap without the declines presented below.

This is not a prediction—maybe we can avoid a move to lower P/Es and keep this secular bear in hibernation. The result, after recovering from the recent cyclical bear market, would be approximately 6% total returns from the stock market including inflation; yet, it would avoid the devastatingly-low returns marked by full secular bear markets (see “Waiting For Average” at for a tally of the future expected return).

Nonetheless, since one of the most common questions is “when will this secular bear market end,” the table in Figure 5 seeks to answer that question and to highlight that secular market cycles are determined by ‘distance’ and not by ‘time’.

Figure 5. Distance To The Next Secular Bull?

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As reflected in Figure 6, the current level of stock market valuation, as reflected in the P/E, provides the potential for relatively-attractive gains if financial markets stabilize, economic growth continues on average at historical growth rates, and inflation remains relatively low.

A P/E of 22.5 is used as a mid-range for P/Es in low inflation and low interest rate environments with historically average economic and earnings growth.

Figure 6. Stock Market Gain/Loss To Low Inflation P/E Levels

Click on table for larger image.


Today’s P/E is approximately 20.8; the stock market remains in secular bear market territory—close to the mid-range of fair value assuming a relatively low inflation and low interest rate environment. It is historically consistent for secular bear markets to present shorter-term periods of strong returns (cyclical bull markets) followed by periods of market declines (cyclical bear markets).

The only way to reposition into a secular bull market is to experience a decline in the stock market due to significant inflation or deflation. This can occur either by a significant decline over a short period of time (e.g. the early 1930s secular bear market) or by minimal decline over a longer period of time (e.g. the 1960s-1970s secular bear market).

This report assesses the current valuation level in the context of the longer-term market environment. The goal is to help investors and market spectators to assess more quickly the current conditions.

In this environment, as described in chapter 10 of Unexpected Returns, investors should take a more active “rowing” approach (i.e. diversified, actively managed investment portfolio) rather than the secular bull market “sailing” approach (i.e. passive, buy-and-hold investment portfolio over-weighted in stocks).

Author’s Note: For readers that are interested in the topics included in the report and elsewhere at, please note that the just-released book Probable Outcomes: Secular Stock Market Insights provides greater detail about normalizing EPS and P/E than was presented in Unexpected Returns. Probable Outcomes was written to answer two recently popular questions. First, is this secular bear market almost over? Second, what are the likely returns from the stock market over the decade of the 2010s? For more details, please visit

Note 2: Crestmont Research does not analyze the stock market or interest rates with a perspective about near-term direction or trends; Crestmont Research focuses on a longer-term, bigger picture view of market history and its fundamental drivers. Occasionally, the analysis indicates that a position has extended beyond the typical range of variation. In those times, the view can have relatively shorter-term implications. Also in those times, however, markets can take a path that is longer and farther than most investors expect before ultimately being restored toward the midrange position of balance of condition.


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About the Author

Ed easterling Ed Easterling is the author of recently-released Probable Outcomes: Secular Stock Market Insights and award-winning Unexpected Returns: Understanding Secular Stock Market Cycles, contributing author to Just One Thing (John Wiley & Sons: 2005), and coauthor of chapters in Bull’s Eye Investing by John Mauldin (John Wiley & Sons: 2004). . Further, he is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU's Cox School of Business where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets at

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