Weekly
Market Commentary: July 14th 2008
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Fears of recession have given way to fears of inflation.
The odds of a recession in 2008 have declined from earlier
this year judging by the incoming economic data, the
upward revisions to Wall Street economists’ GDP estimates
and, more colorfully, by the odds reflected in bets
placed on the online betting site Intrade, where the
odds of recession have fallen back to a normal level
of 30–35% from 70–75%. 
However, inflation remains a big concern for investors
and is weighing on price-to-earnings ratios, or what
investors are willing to pay for each dollar of future
earnings. The accelerating pace of inflation has weighed
on the stock market. Inflation is a negative for price-to-earnings
ratios since inflation erodes the present value of the
future earnings stream. Historically, when the consumer
price index (CPI) rises over 4% as it has now, valuations
fall  below
the long-term average of about 15. The rate of inflation,
measured by the CPI, over the past 12 months has been
4.2%, and price-to-earnings ratios have dipped under
14.
Over the past five years, there has been an especially
tight inverse relationship between inflation and the
forward P/E of the S&P 500. As clearly illustrated
in the chart, each move has been reflected, and the
trend toward higher rates of inflation has placed increasing
downward pressure on valuations.
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Oil prices have been the primary culprit in higher
CPI. The “core CPI” which excludes food and energy,
remains around 2%. A decline in oil prices to around
$100 per barrel (about where they started the year)
by yearend may take inflation down to around 2%. Historically,
this level of inflation corresponds to a price-to-earnings
ratio of about 16–17. This move from the current 13–14
times is equivalent to a greater than 20% gain on the
S&P 500 index. The last time we saw this type of
shift was in 2006, when oil prices fell by over 30%
and P/Es rose.
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IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.
Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
© LPL Financial
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