by Archie M. Richards, Jr., CFP^®
February 13, 2006

The price-earnings ratios of U.S. stocks may seem high, but they're going higher.

A stock's price-earnings ratio (PE) is the number of times the current price exceeds the company annual earnings. Over the last 60 years, U.S. stock prices have averaged about 14 times earnings.

Now 19 times earnings, PEs have seldom been higher. Most market gurus say they can't keep rising from here.

Oh yes they can.

Here's what the gurus are missing: The economy operates within a framework set by government. When policies are harmful, the economy slows, and both earnings and price-earnings ratios fall. When government stays out of the way, the economy flourishes, and prices and PE ratios go up.

In 1950, the citizens of tiny Hong Kong, which has no natural resources, were 40 percent poorer than the citizens of the large African nation of Gabon, which is loaded with natural resources, including oil. Fifty years later, Hong Kong residents, despite its disadvantages, were more than four times richer than the Gabonese.

Why? Because Hong Kong had property rights, low, flat income-tax rates, no tariffs, business-friendly regulations, few state subsidies, and other hands-off government policies. In contrast, Gabon had limited property rights and considerable government intrusion in the economy.

Severe U.S. bear markets of the past were created by poor federal policies. Beginning in the late-1920s, for example, top tax rates on income were raised from 25 percent to 70 percent and later to a whopping 90 percent. High tariffs were imposed, and the Federal Reserve Bank foolishly reduced the money supply sharply. The government in the 1930s told businesses how much to pay employees, how much to charge, how much to produce, and where to sell. Federal policies caused, lengthened, and intensified the Great Depression. Deflation and widespread bankruptcy prevailed. Stock prices plummeted. Price-earnings ratios couldn't be measured, because companies had no earnings.

Both Presidents Hoover and Roosevelt had the best of intentions. They thought they were doing right. They simply didn't know good economic policies, and neither did the voters.

In the 1970s, the federal government applied a top tax rate of 70 percent on income and capital gains. It imposed wage and price controls and many other damaging policies. Rampant inflation occurred, and stock prices fell sharply. In 1977, big-government liberals attained their greatest Congressional majority. It's probably no coincidence that a year later, price-earnings ratios hit their lowest point, at 7.

Most federal policies of today, while far from perfect, are much more favorable than those of the 1930s and 1970s - especially regarding tax rates. Policies may not seem so terrific, because a thriving economy is always messy. But most people are unaware of how bad conditions were in prior years.

The prospects for improvement are very promising. America's big-government liberalism is dying. Liberals cannot be forthright about their policy goals (bigger and more intrusive government), because such a platform makes them unelectable. They're reduced to being negative and bizarre. But voters here and abroad are learning the basics of good economic policies, which mean limited government and free markets.

When economists and market gurus say that price-earnings ratios must return to average levels, this implies that government will revert to the damaging policies that prevailed in the past. That's utter nonsense. Voters won't permit it.

Congress passes bad laws, all right. For example, the Sarbanes-Oxley Act imposes horrific but useless accounting requirements on public companies. But pressure is building to repeal Sarbanes-Oxley, and death taxes are also headed for repeal.

U.S. policies are almost certain to become less damaging. As a result, both stock prices and PE ratios will continue rising.

Let's say that, during the next 12 years, corporate earnings and price-earnings ratios both double. Stocks would rise by four times, representing a compound annual return of 12.3 percent. This is hardly extraordinary - it's about what stocks have done since World War II.

Not a single economist or market guru I'm aware of has expressed the view presented in this column. In terms of the stock market and economics, the majority is invariably wrong about major trends. My standing alone about price-earnings ratios makes it all the more likely that I'll be proven right.