As we watched the carnage occurring during last Tuesday’s attack on America, and focus on the aftermath of it, it becomes clear that this will change most of our previous observations. The potential glimmerings of economic strength that we outlined in our commentary of August 30, (The Thrill Is Gone!), will now take longer to play out. From an economic perspective, consumer confidence is likely to slip far more than we anticipated. Consumer durable spending, up so strongly through the second quarter is now likely to falter, much as it did after Iraq invaded Kuwait in August 1990.


Historically, stockholders have not welcomed war-like involvements by the United States. The average post-WWII decline after the commencement of war was 12.5%. Most surely this was dictated by uncertainty rather than economic fundamentals. While no one can predict the short term, it seems that selling could outweigh buying over the next few weeks. As investors, however, we need to identify the prospective valuation levels of the market over the next few quarters, not just the next few days.

In our last commentary we advised clients to not get caught up in making their overall investment decisions based on which way the “market” was going. Instead we advised them to focus on sector valuations and earnings momentum. In this report, we will focus on the fundamentals of the S&P 500 index itself.

Many commentators have reflected on the fact that the S&P 500 is trading at a multiple in excess of its average of the last twenty years. This is like saying that bonds are expensive because they are selling at yields well below their twenty-year average. But both bond yields and earnings yields (the inverse of the price-earning ratio) have anticipated inflation as their primary corollary. Additionally, whereas a bond’s interest payment is fixed, a stock’s dividend (earnings) payment is not. Dividend payment is highly contingent on what a company can earn on its investment. The best metric we can use to illustrate this is “return on equity” or ROE. (If you’re confused at this point, please refer to our Primer on Equity Valuation.)


Chart 1 depicts the relationship between the S&P 500 earnings yield (earnings/price) and inflation expectations (from the Federal Reserve Bank of Philadelphia). The most recent inflation expectation is 2.7%. Our assumptions for 2002 are that inflation will remain at this level for the next twelve months. Chart 2 shows the correlation between the S&P 500 price/earnings ratio and the trailing return on equity. We use both of these elements to model an expected price-earnings ratio. Currently, our model’s estimate of next year’s earnings multiple is 22. Given the uncertainty surrounding the duration of our anti-terrorist effort and the continuation of weak economic conditions, we would prefer to use a multiple of 20 times earnings.

Our earnings estimate for 2002 is $52.90, well below the consensus. Applying the above multiple to that figure, we come out with an average price of 1058. This is a very conservative assessment. As was the case in the Gulf War, once there has been some resolution to the conflict, multiples could expand to a premium and produce values as high as 1300. If that were achieved by the fall of next year, it would produce a return of 19%. However, if the market were to fall by 10% (close to its August, 1998 low) over the next month, the return from that level could be as high as 30%.

It’s not so much the “P/E” now, but instead, what’s the “E” likely to be? How will this disastrous terrorist attack change the psyche of the American people? My sense is that this changes everything, and possibly for many years to come. There were some encouraging signs this month such as the National Association of Purchasing Managers report that suggested new orders and production increased in August. But the actual industrial production numbers did not bear this out. Given the lack of retail activity, we do not expect production to increase significantly. Instead, we will remain in the “L” curve until consumer and corporate confidence returns.

Clearly, the destruction in Manhattan will depress airline, insurance, and brokerage stocks. On the other hand, there are industries that will benefit from the billions of dollars that will be spent repairing and upgrading the nation’s infrastructure. In the rebuilding process there will be increased demand for steel, aluminum, glass and industrial gases. Furthermore, defense, oil service, and hospital supply companies should benefit. As we said in our last report (The Thrill Is Gone!), “investors should not concentrate on the “market” but should instead be watching the “sectors”.