Pennsylvania Investment Observer

A Secular Readjustment in the Markets

by Daniel J. Nestlerode

I am often put off by technical words or jargon used by people, including me, when explaining what is happening in the markets. Secular is one of those terms that always has seemed a little fuzzy to me. Secular usually refers to something about religions, but in this case I mean something that occurs over a long period of time, usually many years. So what I mean by a secular readjustment in the stock market, I mean a long-term readjustment of stock prices relative to the profits or earnings of corporate America. In stock market jargon, this is called the price to earnings ratio, where the price is the stock price and the earnings are the profits per share as reported by the company in question. The ratio is produced by dividing the price of the stock by the earnings per share.

Through the course of time, stock prices fluctuate, often with a generally upward bias. Stock prices have been rising in the United States for over two hundred years, with some notable periods of retreat. Corporate earnings or profits have been rising for over two hundred years also, again with some notable periods of decline or adjustment during periods of recession or depression. The relationship of variable stock prices and variable corporate profits results in a ratio call the price to earnings ratio or P/E ratio. Given that the components of the P/E ration are variable, you just might guess that the resultant calculated P/E ratio also varies over the years.

The stock market, specific industries and particular companies all have their own P/E ratios. These ratios fluctuate over time. While studies have been done to measure the overall market P/E ratio, I don't know of any studies that have measured P/E ratios over time for particular industries or companies. With that thought in mind, I suspect that one of the best explanations for the lackluster performance of share prices and market averages has much to do with a secular decline on P/E ratios.

In my forty years on Wall Street, I have seen the P/E ratio for the stock market at a low of 4.8, at the bottom of the market in 1974 and a high in excess of 20 in the bubble market of the year 2000. The average for the P/E ratio over many years is about 12. Recently the P/E ratio has been declining as stock prices stagnate and earnings advance to all time record levels. Why is the P/E ratio declining? The truth is that we don't know why it fluctuates over time. It just does. Statisticians will tell you, however, that as a series of number reaches an extreme, it tends to reverse and move back to its long term average. While corporate American is more profitable than at any time in history, the major market averages languish below their all time highs. Indeed, the market might just languish for a few more years as the P/E ratio continues to shrink.

While all this is going on, what many overlook is that selected foreign markets and particular U.S. markets are doing exceptionally well, despite the overall shrinking P/E ratios. Who are these great performers? I suggest that you look towards small & mid capitalization U.S. stocks and the markets in the Far East. Of course, there is no guarantee that what has been performing well so far will continue to perform well. But these areas are a great place to turn your attention if you are looking for performance.

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