We have addressed the cycle of P/E expansion and contraction many time in the past. Today, we bring you a related study from Bob Bronson’s Capital Markets Research.
Stock market P/E ratios are a mean-reverting phenomenon. Over the past 135 years, stock market P/E ratios have explained about 50% of stock returns over the subsequent decade. During the three periods starting on 1/19/1906, 11/28/1929 and 5/14/1965, market P/E ratios declined between 65% and 75% over the next 14 to 20 years. During the three Bull periods (8/24/21, 6/13/49 and 8/12/82), the stock market’s P/E ratio rose between three- and five-fold.
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P/E Ratio: Cyclical Expansion and Contraction
Source: Bronson Capital Markets Research
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We may be in the same cycle where P/Es are contracting. Market Analysts like Bob Bronson expect the next cycle to start with a market P/E ratio below 10, sometime near Oct 2014.
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Quote of the Day:
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The random links appear to be messed up (pointing to the wrong articles, etc).
Look at the huge deviation from the red line to the downside just before 1920
Look at the huge deviation from the red line to the upside just before 1950.
Additionally look at the down ward slope of the three prior declining red lines (not exactlly the same slope) We are way to early in this process to predict a slope and therefore an end point of “Oct 2014”.
Under “normal” conditions we should expect huge deviations along the way and I just can not agree with the predicted path. Furthermore, we are now dealing with a Fed that does not mind printing money, and letting asset prices increase to excess.
I fully accept your warning and premise, but I think the path will be rather perplexing and unpredictable. So I will not be basing my investments by the above graph.
If there is one thing people can learn, it is that earnings do not drive markets as much as PE expansion or contraction caused by other intermarket factors. I don’t want to sound like a broken record posting the same idiocy on here but earnings in the 70s were better than the 90s. Albiet, just by a hair. But the 70s ended with a market PE of 9.
One more thing. For those who continually post that sentiment is too bearish for a top, quit looking at anecdotal polls. Look at the markets. The Transports are up 80 freakin points in ten minutes. EIGHTY POINTS. 2%! Are you kidding me? The market internals are very bullish and people are plowing money and chasing stocks like no tomorrow.
Links should be fixed now . . .
Whenever I hear Mean Reverting, I think of one of the first things I heard about the markets. Volatility was supposed to be very strongly mean reverting, unlike prices. There are a lot of dead traders waiting for Volatility to Mean Revert back upwards this time. A series can be mean reverting in retrospect and then change character as volatility has – to the chagrin of many who follow axioms! You should always add the caviate to the effect – this series is historically mean reverting WHEN YOU LOOK BACKWARDS in time.
You really need to consider dividend yield as well. If we move back to 4-6% like the 50s then it offsets much of the P/E decline.
It would be great if that were overlaid with interest rates as well.
Any guesses on why the reversion line has trended upward?
“It would be great if that were overlaid with interest rates as well.”
Easterling’s book shows that kind of data (see books on right).
And the major question for my portfolio is this…
Does owning stocks or ETFs with reasonable P/Es (for this example 12 to 16) mean that the downswing will be less painful or just that the eventual upside after all the dust has cleared will be huge?
If I recall, value stocks (<= 1 PEG with > 15% growth) actually outperform almost everything else in the three major bear sections of your graph..
Probably the most useful chart you’ve put up on your pontificatin’, self-amusin’, bloggin’ little website!
There are ancient chords of human psychology hidden in that chart.
I could write you a discertation on the topic, of such magnificent beauty, that it would make you cry… make you wet your pants… make you beg Mrs. Big Pic for 10 days of pure uninterrupted solitude… just to comtemplate the wisdom of it all.
There’s a Mrs. Big Picture? I figured Kudlow & Barry went to swinger parties all the time. Barry, is it true? Does your wife also have a blog?
http://marriedtothebear.typepad.com
Barry,
I think this is a compellig chart. Thanks for posting it.
The Merrill Lynch report is outstanding as well. You couldn’t get this kind of depth & perspective if you watched CNBC for 80 years. There’s a lesson in that as well. Thank you.
Consider P/E=[8.5+2G] X 4.4/Y where G is expected/known earnings growth and Y the rate on high-quality corporates. While there are many approaches this is one and taken from Graham. If you build the appropriate spreadsheet table you can relate interest and growth to PE. Now further suppose that Y = risk-free rate + inflation + risk and that a figure of merit for those might be 4.5+3+3 = 10.5%. IF you run the formala you’ll find that there is no risk premium over treasuries.
Now for a historical note two things. As Bill Gross has hammered home after Volcker’s hardnosed move and Reagan’s backing we saw a 20 year secular decline in rates (which all by itself explains most of the stock market rise). The 2nd – if you look back we’ve gone thru four major periods of major innovations that created new industries and changed the production frontiers for the economy as a whole: rails to coal & steel (1850-1870), chemistry & mass production (1890-1910), gas and electricty (1900-1920 – pick your own dates) and materials(Mrs. Robinson), electronics, pharamecuticals and electronics (1950-1975) plus (1980 – 2000 Phase II computers). The next likely Big Thing is Systems Biology and isn’t likely due for 15 years.
So rising rates on a secular 20 years trend and moderate to low to no earnings growth. PE’s should be contracting. Give or take my sloppiness notice that the dates match up well with the chart.
Dave Livingston