Fed Chairman Ben Bernanke’s speech (http://www.federalreserve.gov/newsevents/speech/bernanke20081007a.htm)
at today’s meeting of the National Association for Business Economics didn’t help the stock market. The Dow fell 508 points, compounding yesterday’s 370-point drop.
The Chairman said:
“All told, economic activity is likely to be subdued during the remainder of this year and into next year. The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance and further increase the risks to growth.”
Translation: We’re in a recession that may last until the end of next year.
Yesterday’s posting said the recession would erode earnings and reduce the P/E, and that these developments would further depress the stock market.
The following chart shows profit margins’ remarkable spring-back after the 2001 dot-com bust. You can see margins’ all-time peak in 2006 and the subsequent slippage in 2006 and 2007. It’s a safe bet that the current recession will depress margins through 2008 and 2009. Margins may even fall below their 2001 trough and recede to depths plumbed in earlier recessions.
Profit Margins
(Click on chart to enlarge)
Recessions shaded
In the next chart you can see profit margins’ powerful impact on after-tax corporate profits. Earnings more than doubled following the 2001 recession. But they were already beginning to turn in 2006 and 2007. As recession erodes profit margins, earnings will head south. How far will they fall? Nobody knows.
After-tax Earnings
(Click on chart to enlarge)
Recessions shaded
As recession spreads a pall of gloom over the economy and earnings slump, the price/earnings (P/E) ratio will also suffer.
S&P, P/E Ratio & Earnings Per Share
(Click on chart to enlarge)
Recessions shaded
Earnings’ strong performance since the dot.com bust kept the P/E (price/earnings) ratio above its historical pre-1990s average of about 15 to 1. That is, robust earnings inspired investors to maintain a high price for stocks relative to earnings. But falling earnings will now erode confidence, reducing the P/E and further depressing stocks.
In sum: Recession will depress both earnings and the P/E. That double whammy will drive stocks into the basement.
(The charts are taken from http://www.beyourowneconomist.com. [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)
© 2008 Michael B. Lehmann
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