Is higher earnings volatility reflected in equity prices?
The period from 1980 to 2000 witnessed falling rates and steady earnings growth leading to significant P/E expansion (i.e., stock prices rising faster than earnings). In contrast, high earnings volatility around a flattening trend has characterized the period since 2008, notwithstanding the sharp cyclical upturn in earnings. This is likely to persist in the aftermath of the financial meltdown and rising geo-political risk - suggesting a less favorable secular environment for equities going forward, especially in the absence of continued rate declines. (See our previous features – P/E Extremes, Equity Valuations and Equities in Transition).
Higher earnings volatility with lower trend growth and upward bias on rates imply range-bound P/E’s between a high of about 20 and a low of 10 (based on trend earnings) - suggesting that current valuations are near their highs.
*Yoav Benari, “An Asset Allocation Paradigm”, The Journal of Portfolio Management, Winter 1988.
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