Price/earnings Ratio (P/E) Compression- Your Magic Shrinking Dollar

 

It looks like the market has topped out for the time being at least. Although stock fundamentals look weak to me we still have the FED (Federal Reserve) pumping billions into the markets so I’m not making any firm predictions here.

 

The chart above shows the relationship of the Price Earnings Ratio (P/E) to interest rates. The Federal Reserve (the FED) tries to control inflation with higher interest rates. The higher rates slow down business activity and reduce demand for products by making the cost of borrowing money to high, this true for both businesses and individuals.

The primary reason for this chart is to show you the huge moves in P/E over time. The normal business cycle is three and a half to four years. The market will rise as interest rates fall for two and a half or three years and then fall as interest rates rise for a year or a year and a half. Unfortunately these are just averages. As you probably know the market has been on a steady rise for the last six and a half years. In my opinion this has been due to the manipulation of the markets by the FED in the form of QE 1/2/3 (Quantitative Easing) over this same time frame. QE put approximately a trillion (yes, the T is correct) a year into the markets. This supported continually higher stock prices in spite a poor to lackluster economy.

With the change in the administration coming soon there will be changes in monetary policy (I hope) coming soon and that is what the markets are preparing for now. The markets generally look six months to a year into the future but they appear to be anticipating the change of administration a year and a half from now at this time.

Let’s take a look at United Rentals (URI)

blog uri weekly 10-1-2015

 

URI has trailing earnings of 7.68 for the last four quarters, with a 15 P/E that would value the company at $115.20. At the current price of 59.65 the P/E is 8.46.Nasdaq.com says future earnings are predicted to be strong with earnings in 2016 coming in at $8.47 and 2017 at $9.62. So why is the P/E at 8.46 now?

Those URI (and others) future earnings predictions were made in a rising market with no insight into a reversal. With a slowing of the economy this is the result. Don’t forget the markets are a forward looking mechanism that generally looks ahead 6 to 12 months. Stock analysts obviously take a little time to switch gears.

URI rents all kinds of equipment. The largest and most profitable segment appears to be construction and other heavy equipment. And there’s your answer. When in doubt check users of this type equipment, such as JEC or FLR for large construction companies, or CAT and TITN for large equipment manufacturers. You will find they are all in the same boat, or even worse declines.

A year ago I was confidently buying most segments of the market (especially retail) at a 15 P/E. Now I’m looking at the 7 to 10 P/E area before I have any confidence in my trade.

In the P/E – Interest Rate chart above notice that P/E dropped into the 2/4 area more than once. Did we have 20 trillion in debt then? Then again, interest rates weren’t ¼ to 2 percent then either. So who knows what the market will do in the long run.

The market is looking at low or non-existent growth, rising interest rates, a new regime in the white house, the end of QE3, a market that has run up much too long and numerous other problems.

For those of you in a 401k/IRA type account who don’t want to watch the market on a daily basis, I would suggest putting your money in treasuries and comfortably watch the market until the carnage is over.

Dave Cappaert

 

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