Historic PE ratios may indicate Equities are set for a 20% rally in November

With better than expected earnings announced in 2011, as well as falling prices in world stock markets, equities have become exceptionally cheap when measured against historic earnings. Price to Earning (PE) ratios on the S&P 500 are now at their lowest level since 1988. This may indicate that equities are set for a strong end of year rally that may be as much as 20%.

The PE ratio measures a company’s value in multiples of its yearly earnings. The historic average PE ratio on the S&P 500 is 16.41. With recent drops in equity prices this ratio has now fallen to just 12. Other markets have been affected even more. The German DAX has seen PE ratios drop to as low as 9 in the past few weeks.

PE ratios are only one way to value the stock market. If the current economic problems persist and the USA does enter a recession, then it may suggest that earnings will drop next year instead of prices rising to bring PEs back in line with their historic norms. However, recent political moves as well as better than expected economic data may call a halt to the present drops causing a substantial rally in equity prices.

The principal concern at present is the Eurozone crisis and the handling of the Greek default. Some fear that a Greek default may cause ripples through the banking sector causing a Lehman Brothers style event.

However, the Greek default is a very different event to those of late 2008. Firstly, European banks have gone through two stress tests where the scenario was a Greek default. Secondly, unlike the Lehman Brothers event where AAA rated securities went to junk status overnight, Greek debt is already at the lowest possible rating above default. Indeed the price of Greek government debt has fallen by so much that the interest yield has climbed to as high as 70%p.a.

The bigger concern in the markets is that the current crisis could move to Italy and Spain. However, it seems likely that European leaders will agree on an expansion of the European Rescue Fund from EUR400 billion to EUR2 trillion. The simple threat of 2 trillion Euros should be enough to see the yield of Spanish and Italian debt drop allowing both countries to restructure their finances without threat of a default. Portugal is also likely to require further assistance but it now seems that Ireland will not require a further bail out. World leaders have given the Eurozone until the next G20 summit held in Cannes on the 3rd of November to put this deal in place.

The other major concern at present is the threat that the USA will re-enter a recession in the 3rd and 4th quarter of 2011. Economic data is inconclusive at the moment as to whether this is possible. It seems likely now that weak economic data in the 2nd quarter was a result of a supply side shock caused by the Japanese Tsunami. Many manufacturers who were unable to source components simply shut down or reduced production leading to a knockdown on GDP and a slowdown in hiring; however it remains unclear whether speculation of a US recession may be enough to become a self-fulfilling prophecy. With equity markets down around 20% and PE ratios at 23 year lows a single negative quarter of GDP is well priced in. Even a full blown two quarter recession is only likely to see 10-15% more knocked off equity prices.

It’s our view that the current turmoil is likely to abate by the end of October or beginning of November with the announcement of the terms of a Greek default and an expansion of the Euro rescue fund. While it remains unclear if we will enter another recession, negative GDP growth in the 3rd and 4th quarters already seems priced in. If we do see positive figures then we can expect to see equity prices rally by up to 20% before Christmas.