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Strategies & Market Trends : Roger's 1998 Short Picks -- Ignore unavailable to you. Want to Upgrade?

To: Pancho Villa who wrote (9332)	5/29/1998 12:54:00 PM
From: Oeconomicus	Read Replies (2) \| Respond to of 18691

Pancho, while we're pulling out textbooks, consider this: You used short term rates to estimate PEs which is one way, but it ignores the shape of the yield curve. Damodaran, in Investment Valuation (1996, Wiley), estimates the effect that both the level and the shape of the yield curve (using the spread between T-Bond and T-Bill rates) have on PEs. Regressing data from (I think) 1960-1994, it looks like this: E/P=3.34%+.716TBond-.9039(TBond-TBill) Using 5.8% for the bond and 5.25% for the bill (he wasn't clear about which bill, 1 yr, 90 day, whatever, so I used something in the middle), we get E/P=6.99% or a PE ratio of 14.3. Wow! OTOH (I was an econ major, so I can say that), this approach may give you a bad number if growth is ignored so let's try again. Looking across 9 industrialized nations with varying long and short interest rates (yearend '92) as well as expected GDP growth ('93), he got the following: P/E=41.85-.20ShortRate-3.44LongRate+3.21GDPGrowth Using the rates above and a market PE of 27.5, the implied expected GDP growth for the next year is 2.1%. Not so wow. I don't have three hands, but if I did... OTOH, what if earnings growth matters more? Long-term eps growth on the S&P 500, from 1926 to 1997, has averaged about 5.1% per annum. Since 1981, it has been a little higher at about 5.8%. Long term real economic growth is a little lower since eps includes inflation, but above the 2.1% number implied above (old data I have comes to about 3.1%). Does anyone really think that this year will be an above average year for earnings or for the economy as a whole? Using your PE=1/r-g, you indicate that the current PE implies a g of almost 10%. Remember, g is perpetual growth. What if 5.8% is the correct number for g? Let's be generous and use 6.0% (new era, you know). The PE, then, should be 13.3. Wow again! I'll be more generous again, remembering that you ignored the yield curve. Using long-term rates and the long-term risk premium of 5.5% (again according to Damodaran), we get an implied growth rate at a 28 PE of 7.7%. At 6.0% growth, the PE should be 18.9. Finally, a number that makes some sense to me. At 7.0%, it should be 23.3 BTW, but how optimistic are we about long-term growth? Remember, we may be starting the long term with a zero or worse. I'll take a PE below 20. Not the end of the world to get there, but at 70-75% of the current S&P value, enough reason to be out or even short. Regards, Bob PS: This outlook assumes Asia doesn't put us in a deflationary spiral. If earnings are going to decline sharply for a year or more, long-term growth from current S&P eps won't even be average. At 5%, the PE goes to 15.9.