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Whatever the outcome, our sense remains that the various markets will revert to a focus on the issues evident prior to the recent hostilities. Those issues remain a softening real estate market, rising interest rates, high energy prices, inflation, a weakening dollar, P/E multiple compressions, waning earnings momentum, weakening consumer spending, flat wage growth, and declining GDP momentum. And to that GDP point, it is worth nothing that while we have a healthy distrust of the government’s measuring metrics, the one thing you can trust is tax receipts. And surprisingly, tax receipts are growing at around 10%. Ladies and gentlemen, 10% growth in tax receipts just does not “foot” with 2.5% GDP growth. “Somebody” is lying! Either tax receipts are getting ready to collapse, or the economy is going to continue to surprise on the upside. If economic strength is the “call,” then while the Fed may pause at its August meeting, it is certainly not done with its parade of rate ratchets. If, on the other hand, the economic slowing is about to accelerate, the concurrent loss of earnings momentum is not a particularly pleasant environment for stocks.

As for the ubiquitous argument that stock P/E multiples are cheap based on forward-looking earnings estimates, hereto we are skeptical. Indeed, P/E ratios on forward-looking earnings are almost always lower, making stocks look undervalued. That was the case in 2000, 2001, 2002, etc. It is just the nature of Wall Street to overestimate earnings. Yet, the real driver of stock prices is what investors are willing to pay for those earnings, and as we have suggested for the past few years, P/E multiples are compressing due to rising inflation and rising interest rates. And that is why, despite double-digit earnings growth as measured by the S&P 500, stocks have gone nowhere for the past few years. That said, there is always a bull market somewhere and for the past few years we have suggested it was in small/mid-capitalization stocks, “stuff stocks,” Japan, Canada, emerging markets, etc.

Here's a table on how the market has reacted during different wars (FactSet provided the data).

Posted by edelfenbein at July 26, 2006 3:30 PM