PE EXPANSION IN 2006!

Conditions are ripe for the multiple to multiply in 2006. One way to measure the expected or fair PE ratio is to use the old rule of 20. The rule of 20 is better than the old rules of 18 and 22 because the average makes for easy comparisons and the rule is more of a guideline than a rule. There is not a precise mathematical relationship.

The rule of 20 says the current PE on the S&P 500 should roughly equal 20 minus the yield of the 10 year Treasury note. The current yield is about 4.35% leaving a projected PE ratio of 15.65.

There is a bunch of good news in the above projection; especially if you combine the above projection with the projection of future earnings and the projection of future yields. The bond market yield curve is currently projecting lower interest rates and, although the second derivative of earnings growth is down, an increase in earnings is predicted.

I like forecast derived from the bond market. This big institutional market is right more times than not. This market is clearly calling for lower interest rates. Think about it, if you were managing 10 Billion Dollars of 1 to 10 year paper would you invest in a ten year note at 4.35% or a 5 year note at 4.31%. You would have to have a strong belief that interest rates are headed down before locking into the then year paper.

Projections of earnings growth are complicated by numerous factors. For example, the trend has been better than expected earnings growth for four years in a row. Analysts have consistently been wrong but in a good way for those of us who have been bullish. Another factor is that much of the earnings growth has been in oil or oil related stocks. The rate of growth in the oil market rate of growth is slowing.

Ed Yardeni, one of my all time favorite economist, uses general economic statistics such as ISM indicators to project earnings growth. Suffice it to say that there are many indications that the rate of growth in earnings may slow in 2006 but the growth still could even possibly hit double digits again.

The bottom line is that it is rare for the PE of the S&P to be below the rule of 20 PE. In past instances, PE's usually expanded. In the past, a flat yield curve has usually correctly predicted a decline in interest rates. A decline in interest rates would increase the rule of 20 PE even higher. In the past few years, analysts have underestimated earnings. An increase in earnings would widen the spread between the S&P PE and the rule of 20 PE. Add all these indicators up and one can envision a 30% gain in the S&P during 2006.