Why Stocks May Not Go Down the Drain

BACK IN HIGH-SCHOOL MATH CLASS, ONE OF THE PROBLEMS I hated was this: A bathtub is filling at x gallons per minute, but water is draining at an (x-1) rate. How long before the 60-gallon tub is filled? The math geniuses -- most of whom probably run their own quant shops now -- figured it out relatively quickly, but I struggled. I'd always think, why not plug the drain?

Think of the market as the tank, substitute earnings growth for the water coming in and inflation for water going out, and investors are facing a similar challenge. The inflation rate has a crucial inverse affect on the market's price-to-earnings ratio: Higher inflation depresses P/E multiples, while lower inflation allows P/Es to expand, or the tub to fill, because companies lose less profit to inflated costs.

The latest figures suggest the worst, inflation up and earnings down. Thursday the July inflation estimate was released: up 0.8%, due to rising food, energy, airline and apparel prices, and up 5.6% from the level 12 months ago, for the highest jump in 17 years. Meanwhile, S&P 500 earnings were down about 22% in the second quarter, after falling 16% in the first, with most of that damage in the financials. With a global slowdown under way, the likelihood is that S&P 500 profits will show further quarterly drops, perhaps for the next six to 12 months. In other words, water is entering at a slowing rate, just as it's now draining at an accelerated pace.

But you don't need calculus to know that as bad as inflation is right now, it's likely to subside over the next 12 months, perhaps enough to mitigate the damage from earnings declines. Profits will drop, says Morgan Stanley European strategist Teun Draaisma, but history suggests that falling inflation could help expand P/E multiples enough to cushion the blow, keeping the overall market roughly where it is now. Morgan Stanley expects the U.S. inflation rate to slide to 2.8% by the end of 2009. Commodity prices, which have fallen significantly, will soon be lapping the outsized increases of 2007.

During past recessions in developed markets, he adds, at some point inflation peaked, even as profits still had a long way to fall. "In Europe, for example, in the 16 months beginning December 1974, corporate earnings fell some 40%, but the P/E went to 14 from six, and the market rose about 50%." Before you push the Buy button, Draaisma is looking for a flattish market, not a big rise, because the expected inflation drop won't be as large as those in previous recessions, nor is the current U.S. market P/E, about 14-15 times 2008 earnings estimates, as low as those in past contractions.

And there's a caveat. (There's always a caveat, isn't there?) The strategist sees a "garden variety" recession. A long and deep economic malaise could overwhelm the balm from lower inflation. Now, if we only had a stopper.