Multiple Compression Could Turn Into Multiple Expansion With Lower Commodity Prices

Following a solid spring, a combination of macroeconomic and industry specific factors began to be manifested retail.  These have been well cataloged and include higher transportation and energy costs, the economic impact of the fall hurricane season, rising interest rates and concerns about increasing inflation and a slower economy.  This is a pretty depressing litany of factors outside our control, but most are not altogether new…

– Paul R. Charron, Chairman and CEO, Liz Claiborne

Liz Claiborne isn’t alone in feeling the effects of high transportation, energy, and interest costs.  I would argue that the entire market is being compressed by these factors.  By compressed, I’m referring to a phenomenon called "earnings multiple compression." 

As a matter of background, investors are usually willing to pay a certain multiple of earnings (referred to as the Price/Earnings (P/E) multiple) for a stock based on its growth and quality characteristics.  Investors will pay a higher multiple for strong companies with consistent, sustainable earnings growth (for example, Ebay trading at 38x earnings) while investors will pay a much lower multiple for highly cyclical companies (for example, homebuilder Toll Brothers trading at 7x earnings).   

That implies that there are two key variables to figuring out what investors will pay for a stock – the earnings themselves, and the multiple of those earnings.  Typically, when stocks move significantly higher, it’s not just the higher earnings that investors are taking into account – they are also willing to pay a higher multiple for those earnings.  Investors are inferring that the earnings growth is sustainable and are willing to pay a higher multiple for that growth.  Similarly, when a stock collapses because of poor earnings, investors are not only factoring in the lower earnings estimates, they are also paying a lower multiple for those earnings. 

The same phenomenon applies to the overall market.  When investors are confident of future earnings growth, they are willing to pay a higher multiple for all stocks.  The huge market run up in the late 1990s was mainly the result of "earnings multiple expansion."  Earnings growth was generally in line with historical averages but investors felt confident that the growth would go on forever and began paying a higher multiple of earnings for that growth.  The chart below shows the multiple expansion and subsequent compression on the S&P 500.  The top half of the chart shows the S&P 500 price along with the earnings per share of all the S&P 500 companies.  The bottom half of the chart shows the earnings multiple of the S&P 500 stocks.  Currently the forward price to earnings multiple of the S&P 500 is 15.6x, which is at the bottom of the range. You can see that it has been as high as 27x in the late 1990s. 

Source: Baseline

You can also see on the top half of the chart that the earnings per share growth (EPS is marked by the dotted line) has been strong in the past three years.  In 2006, the S&P 500 companies are expected to earn over $80 per share.  That’s up from about $50 per share in 2003.  So in the past three years, earnings have grown by about 60% but the S&P 500 is only up 35%.  Investors are clearly not willing to pay a high multiple for the earnings of the S&P 500 companies. 

You can also see this phenomenon by looking at a long term price chart of the S&P 500.  The rally from 1996 to 2000 broke out above the long term trend channel that the market had carved out from the early 1980s.  While prices often break above or below long term trend channels, the fact that the S&P 500 stayed above the price channel so long is truly amazing.   The multiple expansion of the late 1990s caused an aberration on the price charts. 

Currently, investors aren’t willing to pay a high multiple for the earnings because of the factors listed so succinctly by Liz Claiborne’s Chairman.  Investors have low confidence that the earnings growth is sustainable because of the high commodity and input prices.  These costs can be viewed through the lens of the CRB index, which measures a broad basket of commodities.    The chart below shows the CRB index in the third panel of the chart.  You can see that since the CRB broke to new highs, the S&P 500 multiple has remained relatively flat. 

Source: Baseline

Typically, the higher CRB index would imply higher rates of inflation.  And that would normally translate to higher interest rates.  However, that has not occurred during the past three years.  Interest rates remain at relatively low levels, as the chart below shows.  The ten year yields have just now started to creep up to the top of the range. In addition, the inflation adjusted 10 year TIPS have just now begun moving higher.  That’s part of the "conundrum" that Greenspan kept talking about.  There’s clearly inflation in commodity prices but interest rates haven’t reflected it.  This presents a potential problem – if interest rates start moving higher on top of the high commodity prices, the earnings multiple of the S&P 500 could be compressed even further down.    

Source: Baseline

However, if the opposite happens, that is, commodity prices stabilize and begin moving down, then the interest rates will probably remain a moot point.  Currently, I’m watching two key commodities for signs that commodity prices will move lower.  The first, crude oil, is being watched by everyone.  The second, steel scrap, is a bit further off the radar. 

Source: Baseline

If these commodity prices begin declining, the "earnings multiple compression" currently affecting the market could turn into "earnings multiple expansion."  Right now, the market is trending at the bottom end of the long term price channel.  I believe the market could easily move back to the middle of the long term price trend.  That would imply a move to 1,500 or 1,600 on the S&P 500.  I believe that a "earnings multiple expansion" led by a move lower in commodity prices could spur such a move higher in the S&P.