Not That 70s Show  

commentary from this week’s “Sectors and Styles Strategy Report”*:

There has begun to be a fair amount of talk re stagflation and its consequences, both economic and equity valuation. Should the experience in the coming years resemble the stagflationary era of the 1970s, then P/E levels are more than justified to crumble to single digit levels, as they did then.

Dismissing the stagflation threat entirely would be a mistake. Yet, buying into the idea that a 1970s style stagflation environment is in the current economic cards appears to be equally suspect as the world economy are clearly changed considerably since then. There is, however, a stagflationary scenario that does bear serious consideration – stagflation lite.

In a stagflation lite environment, growth stalls like it did in the 1970s but inflation rises at a much more modest degree. In such an environment, the economic impact is obviously more muted, this thanks to a more globalized climate.

From a valuation perspective, P/Es, for example, would be lower than they would be in otherwise less stressed times. But not quite to the degree that they were in the 70s.

Investment Strategy Implications

The broad market investment implications of any version of stagflation are rather straightforward – lower valuation levels. Any time quality of earnings is affected, valuation levels must go down.

In a stagflation lite environment, an investor could kiss the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year US Treasury at Approx. 4%) goodbye. Nor would its historical level of 15 times hold. However, only a stagflation period comparable to the 1970s would produce single digit P/E levels as it did then. Hence the higher P/E probability in a stagflation lite world would be somewhere around 12 times earnings.

If that were the case, then an $82 operating earnings (S&P 500) forecast would put the fair value target for the S&P 500 at 984, a full 23% below current levels. Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In the process, the drop of 554 points from the high achieved in October 2007 would match against the 770 point increase from the low reached in October 2002 (to the high of October 2007) and, therefore, would produce a decline of approximately 75% (from peak to trough). Such a drop would result in a slightly greater than your standard major bull market correction of 2/3s.

Be it stagflation or stagflation lite, it does appear to be touch premature to make such a call. Nevertheless, the market may be taking some of this thinking into consideration, and so should we. More on this prospect in the coming weeks.

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