Equities have historically experienced secular bull and bear markets characterized by rising and falling valuations, as measured by the ratio of share price to trend earnings or P/E, in response to lower or higher risk economic environments, respectively. (See our previous feature – Secular Trends). Not surprisingly, equity prices are also impacted by more immediate and direct influences such as earnings growth. Rising earnings growth should boost equity prices, and vice versa. In reality, declining earnings growth has often preceded falling equity prices, but with significant lags, while upturns in earnings growth have at times coincided with equity price bottoms and extreme P/E lows.
The cyclical rise in equity prices and P/Es that began with the upturn in earnings growth in 2009 is at present increasingly challenged by declining earnings growth. This together with a continued risky economic environment implies that current P/Es may be on the high side and that equities are vulnerable on the downside.
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