Previous

Page - 9

When a corporation experiences a burst in earnings, investors may bid up the asset price by a percentage that exceeds the increase in earnings and thus may reward the corporation with an elevated p/e ratio. This new p/e ratio could be based on the idea that corporate performance is a "permanent" condition. Exceptional growth predicts continued exceptional growth.

But be wary of this kind of thinking. An exceptional growth rate cannot last forever. Think about 10-year-old children. One child may experience exceptional growth making her much taller than her classmates, but if this difference in growth rates were to persist, the class would soon enough have one 50 foot tall student and while everyone else was around 5 feet. In other words, a stable distribution of heights or of corporate earnings, does not allow persistence in growth rates. Growth spurts occur. But not permanent differences in growth rates.

Likewise the relatively rapid appreciation of shelter costs in San Francisco after 1995 might be a good reason for an increase in the SF p/e ratio, if you think that there is "momentum" in rents - with high appreciation supporting further high appreciation. This might come from the imposition anti-growth of supply limitations, if demand continued to rise at the same pace.

But, on the other hand, if you think that a region can price itself out of the competition for a workforce, then a period of sustained appreciation of rents (like the 1980s) precipitates a corrective reaction with labor and capital moving to places where rental costs are lower. Thus a period of rapid increases in rents may be followed by a period of stable or even declining rents. Indeed, after a sharp run-up in rents in the late 1990s, San Francisco has experienced stable rents since mid-2001, while LA rents are growing more and more rapidly, as can be seen in the chart below. If we knew that this is likely to persist, with a sustained period of rent appreciation in LA but stable rents in San Francisco, then LA needs a high p/e ratio while San Francisco needs a low p/e ratio. Thus that stable SF e should come with falling p. Instead, what we have is stable e but rising p!

Next

* Edward E. Leamer,
Director, UCLA Anderson Forecast.
Check the link for author's profile: http://www.anderson.ucla.edu/faculty/edward.leamer/pdf_files/cv.pdf