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.
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Good times: Low inflation, low interest rates, low VIX, strong profit growth, high-quality earnings.
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Average times: Moderately low inflation, interest rates and VIX, good profit growth and quality of earnings.
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Bad times (Stagflation lite): Moderately rising inflation, interest rates and VIX, negative profit growth and quality of earnings.
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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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I would add one more category to your article.
That is "Reciflation", which is one step beyond stagflation.
That is recession plus inflation caused by rapidly rising oil prices.
I was looking at a 2006 talk given by Hirsch, which predicts when oil
would peak. The first predicts were for the US lower 48. Since no one was completely sure about the size of the USA total reserves, Hubbert back in 1970 did something very clever. He realized that total production over time was a Gaussian curve.
But he did not know the size of the curve. No one could accurately measure reserves. But he found that if one plots yearly production divided by total cumulative production to date (this function decreases with time, starting at the beginning of oil production), one can predict where the 50% point (Peak Oil) of the Gaussian is.
He did this for the lower 48 in 1970 and found when this ratio hits 52%, you are at peak oil. The function decreases with time.
Now Hirsch looked at the same function for World oil production, and it hit 48.5% in 2005 (beyond the peak). The only difference I can see between the lower 48, and World oil production is that of OPEC. They have held a portion of the yearly production back.
If this analysis is correct (and it is mathematically), then we are now running on OPEC spare capacity. Very soon we shall slide over the peak. At that point Hirsch predicts:
Inflation, unemployment, recession, high interest rates, = "reciflation"
Lets hope we have a few years left.
.. Of course, even that hasn't saved Pres. Bush Jr.'s legacy as the NASDAQ index has stayed less than 1/2 what it was under Clinton and the DOW, despite having failing companies replaced to keep the USA's strongest 30 in the index, is and has spent 95% of the past 8 years LOWER than its peak under Clinton... The Dow took 6 years under Bush Jr. to even just get back up to and then briefly above its peak under Clinton, but couldn't stay above, despite horrendous inflation and attending 50% loss of dollar value helping it... The Dow would have to reach 20,000 or more now to simply equal its peak back in 2000, and the NASDAQ would need to reach about 10,000 or so, far from its pathetic current 2,369...
