Stagflation Lite?

In bear markets, many investors lose sight of the fact that stocks have an inherent long-term upward bias. This upward bias is anchored in a number of factors, including:
 

• Innovation
• Money supply growth
• Population growth
• Fiscal and monetary policies that trend toward expansion
• Productivity gains

Trends and themes such as globalization, technological advances in information and communication, and pressure on corporate management from value-based activist investors also contribute to this upward bias.

However, a long-term uptrend is not a straight line. Driven by economic cycles and investor psychology, bull and bear markets pull valuation levels above and below their long-term P/E average of 15 times earnings.

Obviously, average times are not every time - hence we have  the euphoria of bull markets and the depression of bear markets. With the S&P 500 at 1282 and projected operating earnings for 2008 running around $82, the current P/E sits right around its long-term average rate of 15 times.

But are these average times? And more importantly, what are the economic times likely to be in 2009 and the coming years?

Perhaps investors will find the following simple table helpful. It provides a range of economic scenarios matched up with their appropriate P/E ratios set to projected operating earnings for the S&P 500, along with the resulting projected return on the S&P 500 from current levels.


Click to enlarge

A useful, basic definition of each of the economic times and their P/Es is as follows:
 

• Great times: Low inflation, low interest rates, very low VIX, strong profit growth, high-quality earnings.
  
  
• Good times: Low inflation, low interest rates, low VIX, strong profit growth, high-quality earnings.
  
  
• Average times: Moderately low inflation, interest rates and VIX, good profit growth and quality of earnings.
  
  
• Bad times (Stagflation lite): Moderately rising inflation, interest rates and VIX, negative profit growth and quality of earnings.
  
  
• Terrible times (Stagflation): Rising inflation, interest rates and VIX, negative profit growth and quality of earnings.

Investment Strategy Implications

Based on one’s expectations of earnings, interest rates, inflation, other real economy matters, and investor psychology (after all, investing is a mind game), the scenarios and data listed above provide a useful template for investment planning.

For example, one such outcome that has gained a considerable amount of traction of late -- “stagflation lite” -- shows stocks still have a ways to go to the downside, even if the S&P 500 operating earnings remain unchanged over the next 12 months ($82).

So, while the long-term bias for stocks is up, knowing what part of that long-term cycle one is in is a necessary for active investors.

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