James Paulsen: Investment Outlook (January 23, 2012)

Main Street Misery Sets Wall Street’s Valuation

Investment and Economic Outlook, January 23, 2012

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
During 2011, the stock market suffered a significant erosion in its price-earnings (PE) multiple. On a trailing four-quarter basis, the PE multiple on the S&P 500 finished 2011 at about 13 times compared to about 15 times at the end of 2010. Rising earnings were offset by a declining valuation resulting in a flat stock market last year. Will the stock market’s valuation revive in 2012? And, what is the outlook for PE multiples during the next several years?

The valuation of Wall Street often reflects the character of Main Street. Indeed, for the last several decades the PE multiple of the stock market has been closely related to the Misery Index (sum of the U.S. unemployment rate and the core consumer price inflation rate) on Main Street. A higher (declining) unemployment rate and/or inflation rate tends to lower (raise) the valuation investors are willing to pay for stocks. In the aftermath of the 2008 crisis, “Main Street Misery” remains high suggesting that Wall Street valuations could rise substantially in future years should Main Street fortunes slowly improve.

PEs and MISERY

The accompanying chart overlays the S&P 500 PE multiple with the Misery Index. The PE multiple is based on the trailing five-year moving average of reported earnings and the Misery Index is shown on an inverted scale (misery rises when the dotted line declines). Since 1970, the sum of the unemployment rate and the core consumer inflation rate has done a good job duplicating the movements of the stock market PE multiple. That is, the valuation of the stock market is consistently impacted by the rate of inflation and labor unemployment on Main Street.

The collapse of the PE multiple in the 1970s resulted from both runaway inflation and stubbornly high rates of labor unemployment. Conversely, the Great Bull Run of the 1980s and 1990s occurred against the backdrop of a steady decline in both the inflation rate and unemployment rate. From 1980 until 2000, the core consumer price inflation rate declined from about 13 percent to 2 percent. The unemployment rate fell from a post-war high of 10.8 percent in 1982 to a low near 4 percent in the 1990s. Lower inflation and declining unemployment combined to improve the Misery Index from about 20 percent to only about 5.5 percent which produced about a four-fold increase in the S&P 500 PE multiple! Since 2000, however, although the core inflation rate has trended sideways, the unemployment rate has surged causing a near doubling in the Misery Index, and a halving in the S&P 500 PE multiple. It appears “Misery on Main Street” establishes “Valuation on Wall Street.” Therefore, what is the outlook for “Main Street Misery” and what does it imply about future stock market PE multiples?

A Little “Misery Math” for Stock Investors?

Currently, the Misery Index is 10.7 comprised by an 8.5 percent unemployment rate and a 2.2 percent core inflation rate. The stock market’s trailing 5-year PE multiple is about 16.5 times. What does a little “Misery Math” imply for the stock market in 2012?

The pace of job creation finally appears to be strong enough to produce a slow but steady decline in the unemployment rate. A modest assumption for 2012 would be the unemployment rate declines to between 7.5 percent and 8 percent. The core consumer price inflation rate is also likely to moderate this year. A significant decline in commodity prices last year, a recent moderation in core producer price trends (sixmonth annualized core PPI inflation slowed to 2.3 percent in the second half of 2011 versus a 3.7 rise in last year’s first half) and a continued deceleration in wage inflation suggest a mild decline this year (perhaps to between 1.5 and 2 percent?) in core consumer price inflation. Assuming the unemployment rate declines to 7.7 percent and the core consumer price inflation rate drops to 1.8 percent, the Misery Index would fall to 9.5 percent in 2012. The accompanying chart implies about a 19 to 20 PE multiple with a 9.5 percent Misery Index. Finally, assuming 2012 S&P 500 earnings per share reach current consensus expectations of $105, the trailing five-year average earnings would be about $80. A 19 PE multiple applied to $80 yields a S&P 500 target price for 2012 of 1520.

What does the Misery Index suggest for the stock market longer term? Looking out a few years is, of course, much more uncertain. However, if the recovery continues for the next four years, the unemployment rate would likely slowly decline to between 4 and 6 percent. The real wild card for the Misery Index and therefore the stock market longer term is what happens to core consumer price inflation. Assume the unemployment rate declines to 5 percent, but consider three different inflation scenarios—a high inflation outcome of 10 percent core inflation, a medium inflation outcome of 5 percent, and a low inflation outcome of 2 percent. It seems reasonable that as the recovery matures, core consumer inflation will not likely be much lower than it is today and could be substantially higher.

Finally, we conservatively estimate that four years from now, five-year trailing S&P 500 share earnings would reach $120, $115, and $110 respectively in the high, medium, and low inflation scenarios. What are the implied four-year forward S&P 500 price targets for each of these scenarios? The high inflation scenario implies a 15 percent Misery Index and from the accompanying chart this yields a PE multiple of about 11.5 and a future price target of 1380. The medium inflation scenario yields a PE multiple of 18.2 and a price target of 2093. Finally, the low inflation scenario implies a 27 PE and a price target of almost 3000!

Summary

As the accompanying chart illustrates, Main Street and Wall Street are closely connected. Misery on Main destroys the Valuation on Wall!

For 2012, the stock market could be driven higher by improved optimism and renewed confidence resulting from a slow but steady decline in the unemployment rate. Indeed, the relationship between the Misery Index and the PE multiple suggests a 1500 price target for the S&P 500 is reasonable assuming only modest declines this year in the unemployment rate and core inflation.

Long term, however, what will prove most important for Wall Street is the inflation outcome. If the character of the contemporary recovery is ravished by surging inflation, the stock market may reflect ongoing Main Street Misery by extending its decade long sideways trading channel. Alternatively, should inflation remain reasonably contained during the next few years of this recovery, stock market valuations may surge higher as the Misery Index on Main Street steadily improves.