At what PE will the broad market settle?

by Wayne Ferbert on September 25th, 2013

I have to admit, as I watch earnings announcements AND the price of the overall market, I feel like I am watching a roulette wheel. Not because I think the markets are like gambling. I don’t think that way at all – quite the opposite.
But because I think of the roulette number as what PE multiple that investors are going to settle on for this market. Earnings in the post-collapse market have recovered for all industries except Financials. And we know the only real absolute growth in the S&P 500 earnings in the last year has come from Financials – ie, all other sectors really netted out to zero gains.
So, in the end, assuming mid-single digit earnings growth for the next 12-24 months, how much will investors be willing to pay for that? In the end, the multiple that investors pay is a reflection of the risk premium they expect to be paid for being invested in stocks. As interest rates were driven to zero, investors had incentive to accept lower risk premiums because they could borrow for cheap. However, as rates go back up, the risk premium they want to be paid has to go up. If it goes up, then the multiples for these companies HAS TO GO DOWN.
That trend should put downward price pressure on stocks. But it made me wonder: what does today’s PE multiple look like compared to the pre-crash multiples and the historic multiples? In other words, what kind of risk premium were investors once willing to accept in a more normal interest rate environment.
Below is the 10-year Case Schiller PE multiple for the S&P500 – cyclically adjusted. In addition, I have included the last 40 years for comparison.
And what do we see? Certainly before the crash, investors had settled in on a multiple in the mid- to high-twenties. But thru the 1970s, 1980s, and early 1990s, we saw a materially lower multiple in the market – in the mid-teens.
So, which market multiple do we think we will return to? I ask you this: after what happened in 2008 & ’09, do you think the average investor is willing to accept the same risk premium he accepted before the market implosion of ‘08/’09?
I say that investors want more risk premium – hence, multiples will need to go down. Think about it – after what you lived thru with your portfolio in 2009, do you have a new appreciation for the real risk in your equity holdings? As a result, don’t you have higher expectations for what you need to get paid to have the same exposure to equity markets? 

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