What Will the Stock Market Return over the next 10 Years?

I came across an interesting historical chart of the post ’29 market, and posted it last night without comment. It was an accidental Rorschach test — the permabulls took it as proof that I was (wrongheadly) insisting a depression was imminent, while the more bearish among you saw parallels to the present.

It was neither.

The following charts, however (courtesy of John Mauldin), do have implications. They look at the returns you can expect over the next 5-10 years, based upon valuation metrics:

Jeremy Grantham breaks down historic P/E ratios into quintiles,


Note that based upon the histroy of the stock market, we are now in the top 20% of historical valuations. Real returns for the indices when purchased at that price are zero.   

Mauldin writes:

"What kind of returns can you expect 10 years after these periods, on average? Interestingly, the first two quintiles, or cheapest periods, have identical returns: 11%. That means when stocks are cheap, you should get 10% over the next 10 years. The last, or most expensive period, sees a return over 10 years of 0%.

This basically squares with data from Professor Robert Shiller of Yale. To ignore it, they must show why "this time it’s different." In order for someone to predict, as many do, that stocks will return 6 to 7% over the next 10 years, that person must show that values lie between the second and third quintiles–or that investors will somehow start putting more value on stocks, and thus a floor on the market.

The problem is that the average overrun of the trend in a secular bear market is 50%, which is why stocks get so undervalued. By that, I mean stock market valuations do not stop at the trend. They tend to drop much lower. For the bulls to be right, we would have to see something that has never happened before. Stocks would need to drop to values 25% higher than the long-term historical average and no further.

Which is about where we are today."

Of course, this kind of analysis asks the question as to what "typical" P/E is — and what it should be:

"What is the average P/E? If you start from 1900, it is 14.8. Starting from 1920 it is 14.4, and starting from 1950 it is 16.8. So, average depends upon when you want to start counting. Using only the last 56 years, we are close to the average P/E. The Grantham chart suggests we should see a return of 8% a year for the next 10 years.

By the way, if you exclude the years 1997-2002, the average P/E ratio drops by more than a full point! Prior to 1997, the average P/E was 13.8."

Now for the histrocial comparo: I have previously made the case that the present market reminds me of the 1972-73 period.

Have a look at this chart by Ed Easterling at Crestmont:


Esterling notes:

"In 1972, P/Es were almost 18, the market was approaching and exceeding new highs, volatility was low, and the market was in the first half of a secular bear market …what happened next is now history–if it happens again, it won’t surprise the old sages…"

Note the bottom thrid of this chart: P/E multiples kept dropping and dropping. That’s caused multiple compression (see this chart also), and we are about half way through a similar "classic secular cycle."  That makes the present rally "another market high on the way to lower valuations in the future."

I agree with Mauldin, who concludes his 5/5/06 letter with this bon mot: 

"Call me a bear, but I continue to believe we are going to get a chance to buy this market at a much lower level than today’s close."

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  1. spencer commented on May 6

    The “average” PE is one of the most misused data points in the investment game. Over the long run the stock market PE has swung from over 20 to under 10 over something like a 20 year cycle. When you use a term like average it implies that there is some central tendency to return to that average or that it occurs more frequently then any other value. But if you look at the frequency distribution of the PE from 9 to 20 you find that that at any given time that there is about the same probability that the PE will be at any value in that range as another value. That is, the pe is between 9 and 10 about as frequently as the PE is between 14 and 15 or between 17 and 18. There is no central tendency for the PE to converge on a value between 14 and 15.

  2. Barry Ritholtz commented on May 6


    This Chart shows they oscillate, via what appears to be longer or shorter cycles over time.

    We have been in a period where the P/E cycle is swinging lower. I have no reason to believe it stops at fair value (i.e., 14 or 16), when in the past it seems to head down towards 10 (or lower)

  3. Marc Mayor commented on May 6

    I agree with spencer. As I told John Mauldin, there is a flaw in the approach, in my opinion.

    Let’s say the long term average PE is now 15, based on the last 80 years or so. The current PE being around 17, we choose to avoid going long the market.

    Suppose the coming 80 years were to give us an average PE of 45. When we make our calculations in 2086, the average historical PE of the market will be thirty. And then we will say: “based on this strategy, we WOULD have invested in 2006, as the PE was 17, well below the long-term average of 30”.

    As anyone knows, backtested performance looks so much better than real past results. Every day, I have to explain to people the difference between backtesting and real results, as my competition uses backtesting and I don’t.

  4. Barry Ritholtz commented on May 6


    If one beleives the avg P/E over the next 80 years will be 45, then you better get long right now.

    However, if you believe in mean reversion, and expect the average P/E to resemble the range of the past centruy, then you approach the future more cautiously.

    The question is this: What do you think the average P/E will be ove rthe next 5-15 years?

  5. bsteve commented on May 6

    Barry, Any thoughts about Hussman’s peak to price/peak earnings… http://www.hussman.net/html/barrons.htm

    doesn’t this model take care of some of the problems that spencer suggests in the first comment?

  6. Ned commented on May 6

    One thing I have never seen discussed in these historical studies is the quality of the E in these P/E comparisons. Have company managements always been as clever and self-serving in their manipulation of the E? What if today’s E is as hyped up and pumpd as some of the CEO packages we have been seeing? No connection there, right? Tell me I am naive folks but I imagine that corporate management in the “good old days” was somehow different and the E of higher quality and reliability.

  7. Keith commented on May 6

    I don’t know if the point we are at is most similar to ’73 or ’68 or ’76 or whichever peak from the ’66 to ’81 consolidation. We could probably argue that out for a long time.

    But the post-’29 and post-’66 periods both had more than one down leg. I suspect that, given our high P/E ratios, we will have another one too. Hence, I also believe that we will see these prices again.

  8. Marc Mayor commented on May 6


    I have no opinion about how high or low the average P/E will be over the next 80 years.

    My whole point is: when you backtest, the math just doesn’t add up. Here is a practical example, a bit closer to reality. Suppose you have the following theoretical numbers:

    In the year 1990, the P/E was 11, markets went up 15%
    In the year 1991, the P/E was 13, markets went up 10%
    In the year 1992, the P/E was 15, markets went up 5%
    In the year 1993, the P/E was 17, markets were flat
    In the year 1994, the P/E was 19, markets went down 5%

    As of 1995, your average historical P/E is 15. Based on the information you have then, you decide to go long the market only when the P/E is below your historical average of 15.

    Now suppose that, in 1995, the market corrects and the P/E goes down to 16. It is still higher than the historical P/E, so we decide to stay out of the market.

    Despite that, let’s say there is a bubble and in 1996 the average P/E is 28.

    In 1997, when you look at historical numbers, you find that the average historical P/E for the last seven years was 17 (11+13+15+17+19+16+28)/7.

    So we would say that, based on our studies, we would have been long the market in 1995, as the P/E was 16, which was lower than the long-term average of 17.

    In 1995, we actually stayed out of the markets. In 1997, we assume that we would have been invested in the markets in 1995 and that we would have captured all the upside, but it’s plain wrong.

    Backtesting always looks better than reality. But people never make money on backtesting, they always get hurt.

    In this case, I believe that the thinking process is flawed. And if you invest based on a flawed theory, you will get hurt and lose money.

    Sorry for the lenghty post, I just feel strongly about this.

  9. royce commented on May 6


    Shiller covered all this is “Irrational Exuberance.” (It was later echoed in Ben Stein’s book on market timing- though Stein doesn’t carry the same intellectual weight as Shiller).

    It’s kind of depressing for the average guy like me, who isn’t a trader and won’t claim to some special insight on the future movements of the market, but I try to look on the bright side. If a person’s investing horizon for retirement is towards retirement the secular bull market will allow a lot of shares to be accumulated cheaply over time before the next big run up.

  10. B commented on May 6

    To discount the past is foolish. To assume the exact scenario will repeat is foolish. But, one should remember the constant that has never changed since the advent of free markets. Economics is a social science. Human behavior has never and will never change. Human behavior drives markets. Not PE ratios.

    “Average” as a single variable applied to PEs is a misused term applied by people who likely don’t understand mathematics or markets. If I have three people in a room and one weighs fifty pounds, one weighs 300 pounds and one weights 1800 pounds, what does the average tell you? It tells you that you are likely clueless if you are trying to derive anything from that single data point. “Average” applied to market returns is similarly misunderstood. Backtesting applied to PE ratios seems a rather odd statement to me. Rather a similar misappropriation of simple mathematical terms. Free markets have a very high kurtosis. One needs to understand what drives that behavior and apply it accordingly to asset allocation models and expected future behavior. Instead we get advice to invest in ten, twenty or even thirty asset silos to minimize our risk. Yet, is that really true? Blockheads (A liberal interpretation of Warren Buffett’s philosophy) who apply this pissing in the wind approach to asset allocation simply don’t understand any of this so they shoot at everything and hope something goes up more than something else goes down.

    The broad sweeping strokes of history rhyme quite nicely. The minor oscillations are but noise affected by generational perturbations. ie, There is a sweet sound of music in historical market PE ratios and how they operate. But, in order to divine that information, you must be able to play the appropriate musical instrument. Anyone who talks of backtesting PEs isn’t someone I want to have guiding my investment philosophy. Just my opinion.

  11. Dennis Chan commented on May 6

    I think all these historical statistics and comparisons are useless now because this is a new era. Why do I think this is a new era? After all, it is often dangerous to reach the “This time it is different” conclusion. Well, now the BRIC (Brazil, Russia, India and China) finally joins the capitalistic system. So there is an additional 3 billion people in the new system versus the roughly 800 million people in the existing system. The people in BRIC desire the living standard of their western counterparts and they are willing to work hard for it. So the amount of wealth created and will be created will be simply massive. The companies that adapt to and take advantage of this changing environment will be minting money. Many of these companies are just happened to be in S&P, Nasdaq and Dow Jones. No wonder all these indexes are reaching multiyear high.

  12. royce commented on May 6

    Dennis, it’s always “different” in the market. The market’s history includes periods in which the radio and telephone were invented, a huge depression, two huge global wars were fought, the formation and break of the soviet union, the gas crisis, the use of space-based satellites for weather forecasting, the invention of anti-biotics- the examples are really too numerous to list. The change in the BRICs is significant, but it’s significance is hardly unprecedented to the market.

  13. Dennis Chan commented on May 6


    Yes, it is always “different” in the market. In addition to the BRIC’s emergence, there is an unprecedented wave of innovations going on right now with Internet being the most prominent. With all these activities happening now, how can one ever believe, as fund manager John Hussman believes (http://www.hussman.net/html/barrons.htm), that right now is the peak in earnings for most corporations is beyond me?

    I believe that we’re still in a relatively early inning of a ballgame that will easily extend to extra innings.

  14. B commented on May 6

    Royce is exactly right. You can go back in history and each time new people were added to the capitalist system, it was a new day. As a percentage of the total, it was always a large change. And, it was always a new day for technological advances of their time. Even when we had large immigrant influxes to the US from Ireland or Germany or wherever in the early 1900s. We had globalization on a large scale in the 70s. Then, in the 80s as South America reformed. Then in the early 90s with Eastern Europe, the Soviet Union and China. Remember, THE STOCK MARKET CRASH HAPPENED AFTER ALL OF THESE PEOPLE WERE ADDED TO THE GLOBAL ECONOMY. To say that “now” all of a sudden these economies were just added is erroneous.

    Oh, and another small point. 2 billion people in China and India are not participating in this revolution at all. They are rural people without running water, an education or making more than a dollar a month. Most do not have jobs as we would define them. Likely very similar to the US in profile of 150 years ago. Or 100 years ago or whatever. So, the Asian horde is incorrect in its basic assumption. It sounds compelling but it is misleading.

    The one thing that global synchronized growth does yield is possibly more of a chance of a serious crisis in my opinion. Structurally, the global economy has not truly changed that significantly from a demand perspective. The US is the world’s consumer. None of the “feeder” nations have really undertaken significant structural reform to create an alternative vibrant consumer based economy. And, because they have the “perception” of creating wealth by feeding the beast, there is absolutely no driver for them to address the issue. To the contrary, they feel very wealthy by simply shoving food down our gullet.

    So, what happens when we’ve gorged until we can eat no more? It doesn’t even need to be shut off. It simply needs to subside. That can be for many reasons. We decide we want to start saving. We don’t have enough money to keep up the pace. The government feels pressure from us to create jobs in the US instead of us choking down everything from China. The dollar is reset either on purpose or because imbalances create a lack of confidence. That cuts off demand as import prices rise. Any one of a dozen scenarios or a multitude more we can’t anticipate.

    Have you ever played dominos? Brazil’s perceived wealth is from China whose perceived wealth is derived from selling goods to the US. India’s perceived wealth comes from trade with the US. It spends that perceived wealth on basic materials from Australia, Russia and Saudi Arabia. Apply that to every economy that is supplying the US either directly or indirectly.

    In the end, their wealth is an illusion. It is an illusion because wealth comes from the consumer class. It doesn’t come from the Chinese government’s building boom. The consumer’s wealth is created by free markets which help drive industriousness, risk taking, creating value, driving consumption and on and on and on. ie, The silly stuff we take for granted in the US.

    So, IF (Big if) the American consumer for whatever reason decides enough is enough by choice or by necessity, where has the perceived wealth of the feeder nations gone? It has evaporated. POOF! It was a sham all along. Why? BECAUSE THEY NEVER UNDERTOOK THE STRUCTURAL REFORMS REQUIRED TO CREATE WEALTH IN THEIR OWN ECONOMIES. They were too busy being PIGS and thinking America’s consumption of their goods would last forever. America’s consumption may last forever. But, it may not come from them.

    THERE ARE MORE RISKS IN THE SYSTEM THAN AT ANY TIME IN THE LAST FORTY YEARS IMO. Those risks are concentrated in developing markets. China, Russia, Malaysia, India, etc, etc, etc. On the other hand, the eastern Europeans have started to address those structural reforms. And, Britain did long ago. Western Europe and Japan somewhat.

    I know I sound like a broken record, but China is a ticking time bomb. And so are all of the feeder nations supporting it. Especially those based on hard assets. And, the global economy is fantastic until it is no longer fantastic. We’ll collectively screw it up. We always do. It is simply part of the human condition. Will that be in six months? Six years? Who knows. But, we will.

    You’ve got a free blog where someone who understands this gives you the liberty of getting some free education. Use it.

  15. Mark commented on May 6

    If Marc Mayor is right then John Hussman and his Hussman Strategic Growth Fund are wrong. Under Mayor’s scenario, Hussman should never hedge. Hedging is wrong. PE ratios also don’t matter. You can’t tell anything is overvalued because that’s looking in the rear view mirror. PE’s may expand. Infinitely!

    Um, I’m not betting my retirement on this New Financial Physics

  16. bsteve commented on May 6

    Hussman does not wait until the P/E falls back to the average or mean to unhedge his fund. He works with averages and admits that he may be wrong, people can and do win at slot machines, but on average they lose. On average, with a p/e where it’s at right now, you will lose if you go long the indexes for several years. On average, that is.

    The proof is in the pudding. He doubled the funds money in five years, 2000-2005. When you do that, you can keep a low profile during higher risk periods. He’s very aggressive when higher returns can be expected–on average.

  17. Mark commented on May 6

    My point exactly. That’s why HSGFX is a core portion of my retirement portfolio. And because I don’t think I could manage bonds, utes etc any better than he does, so is HSTRX.

  18. DaveB commented on May 6

    In regards to those emerging economies creating huge new opportunities, we have to offset that with the huge retirement of the boomers that is about to hit the markets. That is a huge swath of people that will no longer be giving to the system but taking. They will be selling assets to fund their lifestyles.

    Add to that the reality that as these emerging capitalist societies come on line creating huge demand for products, price will invariably go up. This will be good for the companies selling these goods but it will be a hit to the current crop of consumers who can afford them. If you don’t believe that then just listen to the screams of consumers on any radio talk show when the price of gas is brought up. That shows that prices should have somewhat of a mitigating effect on the new marketplace and if you think that government (most of which are now quasi-socialist at least including the US ones) will stand idly by while the exxons and other manufactureres and producers of the world turn into cash cows then you don’t understand the nature of goverment. Wherever the money is flowing the tax man will soon be “for the good of all” of course.

    One thing I haven’t heard much of that may have a influnce on P/E’s at least a little bit is longer living times. As people’s average ages go up they are able to wait longer on acceptable return on investments. I’m wondering if this factor has an influence albeit a smaller one in order to push up average P/E rations at least a point or two

  19. Dennis Chan commented on May 6

    “None of the “feeder” nations have really undertaken significant structural reform to create an alternative vibrant consumer based economy.” — B

    Well, B, I think a trip to China is in order for you especially now with their Golden Week extravaganza going on. I think it is just an illusion that there are twice as many skyscrapers in Shanghai than in Manhattan, that the constant massive traffic jams in China’s highways are not happening, that there are not really over ten thousands people attending the “Millionaire Faire”, and that LV bags are not really selling like hot pancakes in China.

  20. wcw commented on May 6

    The plural of anecdote is not data. I’ll be a lot more convinced by the BRIC-entry thesis were you to rough it out with some numbers.

    How much growth, where, how much accruing to capital vs labor and inputs?

    “This time it’s different” proponents always bear the burden of proof.

    On backtesting: good point. I predict an out-of-sample analysis shows much the same for PEs, though.

  21. muckdog commented on May 6

    Yeah Barry, but what if one gets their booyah on and listens to Mad Money? There’s always a bull market somewhere.


  22. Bob A commented on May 6

    I like this:
    Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we’re seeing that in commodities and housing…Orgies tend to be wildest toward the end. It’s like being Cinderella at the ball. You know that at midnight everything’s going to turn back to pumpkins & mice. But you look around and say, ‘one more dance,’ and so does everyone else. The party does get to be more fun — and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice.
    Or as Bill Clinton said in 98 or 99 or so.. “one day the cookie jars are all empty…”

  23. Blissex commented on May 6

    «Have company managements always been as clever and self-serving in their manipulation of the E?»

    Well, in the past companies had to deliver DIVIDENDS, and delivering cash is hard and expensive.

    The big change has been that many investors now prefer capital gains, which are driven by earnings, which are unfortunately a totally virtual concept. That is, earnings are the difference between _estimated_ values.

    This is a lot easier to manipulate than dividends.

    There is another interested point: companies reward executives according to DELTAs, that is not how much they return but how much they improve things, and they are not penalized when things go bad. If you call being sacked with $50-100m severance a penalty, I wonder…

    This means that executives have a VERY strong incentive to massage the estimates so that earnings follow a seesaw: up up and up, and then fall as much as possible (writeoffs) to make the next up up and up start from as low a base as possible. And companies even reprice already issued options to the low base…

    Suppose you get a bonus for driving ”earnings” up:
    if you expect a five year tenure, would you rather have earnings be above trend 5% each year or by pulling all stops, getting them up 15% each for the first two years and then below 10% each of the next three years?

  24. Bob A commented on May 6

    Even if you think there will be a precipitious drop at some point in the relatively near term, does it mean you have to ‘be out of the market’ until it happens because it might? Or that you should be wary of trendline breaks and prepared to ‘get out of the market’ in a hurry. There’s a difference there. And “the market” depends if your portfolio mimicks the averages. There will be stocks that go up while the S&P/NASDAQ/DJ30/RUT go down.
    Just like some stocks went up during 2000/2003. And don’t you want to be in them?

  25. Blissex commented on May 6

    As to the ”revert to the mean” or not story, I have my own take: look at this chart:


    That is IBM’s stock over 40 years. IBM is a classic blue chip, and other blue chip stock prices have followed much the same trajectory.

    The first stunning feature of that trajectory is that around 1995 the prices have zoomed up, and they have not come down still. The second is that after the obvious 2000 bubble peak, stock prices have come down, but not to pre-peak levels, like not back to 1995.

    This is particularly astonishing for IBM: IBM was minting money thanks to amazing margins in its almost complete IT monopoly in the 1970s-80s, and now its stock price is way, way, higher still, despite having turned into a low margin conglomerate with a large outsourcing (euphemistically called ”consulting”) component.

    So what happened around 1995? Well, that is a big mistery. My most likely guess is that formula-driven retirement accounts for baby-boomers across the country started being stuffed with blue-chip stocks, and they still are. This is in part what is keeping up prices post-boom for those blue-chips, including the new dot.com ones. All those stocks socked away in long term accounts are not being sold, because the formula is buy and hold.

    Eventually the same formula dictates that as people near retirement, their retirement accounts should switch from stocks into government bonds. There may be a huge selloff in 5-10 years time of these blue chips. It could be a deluge…

  26. B commented on May 6

    I appreciate your comments. I also appreciate that there’s a high probability you are of Chinese decent since I don’t too many people from Italy with the last name of Chan. I can feel the pride in your statement that China has finally come of age. And I truly appreciate that. But, I’m talking about economics. Not pride.

    You should never confuse how many skyscrapers are in Shanghai with the point I was making. As it pertains to the point I was trying to make, why is the number of skyscrapers in Shanghai any different than the number of tanks the Soviet Union had? There is ZERO difference. It is a forced march of production that is not market driven. In addition, Shanghai is a city of what? 25 million? I am quite confident a huge number of its residents are not participating in this supposed boom. A good friend’s wife is from Shanghai and her family still lives there. And how does that address the fact that 900 million Chinese don’t have running water or aren’t participating in this supposed boom? Have you ever heard of Charles Ponzi? You might want to read this.


    It is representative of the Chinese “miracle” in many respects. Which, by the way, is no different than the American condo flipper’s miracle. But, the significant difference is ours was demand driven. But, in both scenarios the last person caught holding the bag is screwed. In China, the bag is gigantous and NOT market based. Maybe you’d like to study a little bit of the Japanese miracle which was significantly more market driven than China as well.

    It goes a little something like this. The Chinese government needs to create jobs to the tune of nearly 9% growth simply to create an environment of break even employment. In the US that number is about 100,000 jobs per month. In order to accomplish this, they start a supply side driven approach of construction. The construction fuels employment and perceived wealth with the understanding the residential and commercial real estate has little or no underlying demand at the prices the real estate cost to build. But as long as there are great public works projects fueled by government loans, there is perceived wealth. They hope to create enough wealth to actually fill the real estate. Some real estate is filled by an elite few in China who can actually afford it. Much is sold to speculators. Much is filled with multi-national companies and consumers who actually do work on a system of profit and loss and thus they can actually afford it. But, eventually, there is not enough demand at the cost of the supply.

    So, unlike the US where the markets work and private industry has to float investment via bonds, debt or cash flow, it is funded by government financed debt. The majority of which is nonperforming. As much as 70% by some accounts. So, what happens when the building ends? What happens when the demand, much from foreigners as well, drys up? China’s economic miracle is to sell us exports. If that shuts off, the little perceived wealth that was created is gone.

    The government is left with alot of shiny new buildings and condos with no buyers. What happens? Do they call the loans in? Do they let them rot? What do they do? I don’t care how many reforms people talk about in China. It’s centrally planned communism. And there are no consumer based reforms under way to fix the mess that will eventually come.

    So, when you tell me how many skyscrapers are in Shanghai, I say how many tanks did the Soviets have? A hell of alot more than we did. But, in the end, they also had no consumer.

    You should go to Google News and type in IMF and China. Read some of the commentary from the IMF to China advising them of impending doom. But, I guess the IMF is likely wrong. It’s different this time.

  27. Blissex commented on May 6

    A small addition: the graph above, like that for most blue chips, shows a definite halt of the post-2000 fall a few years after 9/11/2001.

    My impression is that not only formula investment has first pushed and then propped up prices, but also the colossal amount of deficit spending by the USA government as the wars it has started have been funded entirely without taxes, in part to favour high earners (on which war taxes usually fall harder), in part to make the war less unpopular than it is.

    The resulting colossal keynesian stimulus has put a lot of extra cash in the hands of those that buy (or trade!) assets.

    And buy assets they would, because if deficit spending on such a scale follows historical patterns, inflation will be the result, and in that case financial asset with claims on real assets, like stocks and housing, tend to appreciate in line with inflation, unlike cash and bonds.

    I think since ten years ago we have been living in momentous times.

  28. Dennis Chan commented on May 7


    This is silly. I don’t know why you would bring ethnicity into this discussion. The only color that I care about is green, the color of money. We’re here to make money, are we not?

    There are 300 million middle class in China, up from practically zero twenty five years ago. They will buy lots of stuff from our companies which will then make lots of money. So their earnings will increase, and their stock prices will follow. This is such a common sense and simple concept. The fact that so many of your bears fail to comprehend is utterly puzzling to me.
    Yes, there are still 900 million people in China who are dirt poor but this simply represents a huge opportunity for improvement and yet a bigger market for our companies to sell into.

  29. Zephyr commented on May 7

    The P/E ratio cannot be properly judged without also looking at the prevailing environment for inflation and interest rates. The “E” must be adjusted for inflation to measure a real return. Comparison to investment alternatives must also be measured. Accordingly, the yield on long bonds must be considered relative to the P/E ratio.

    As interest rates decline the P/E should rise. Interest rates rose dramatically from 1973 to 1981. Accordingly the P/E should have also declined dramatically, as it did. If those high interest rate levels are the long-term norm then we should expect to see similar low P/Es as the norm. However, in today’s interest rate environment the long term average P/E ratios should be closer to 20 than 15 , and certainly not at all near 10.

    Of course, if you expect rising inflation and higher long-term interest rates to prevail in the future, then a lower P/E should be expected as well.

  30. john commented on May 7

    Dennis Chan – I agree with your comments. At one time the U.S. consisted of a mini-aristocracy (the wealthy banking class), a small “middle class” (the tradesmen and shopkeepers) and the rest who were mostly dirt poor folks. We seem to have gotten over that condition fairly well. I’m sure China will do the same.

    As far as PE is concerned there is so much to say but I’ll just say this – given your choice between two stocks – one with a PE 10 points below the average PE and one with a PE 10 points above – and that is all you knew about them – which would you select for your portfolio?

    I’ve learned through trial and many errors that low PE stocks are low PE stocks for a reason and it usually isn’t a good one.

  31. Frank Rizzo commented on May 7

    Dennis Chan –
    What B is referring to is the correlation between skyscraper booms and subsequent economic downturns. See here.

    The Chrysler Building and Empire State Building were came with the US depression in the 30s. The World Trade Center and Sears Tour came up in the 70s, and Canary Wharf in London in the late 80s, both times with slumps. Citing Homer-Dixon here, it shouldn’t come as any surprise, as the height of an economic boom comes with showiness and extravagance rather than fundamentals.

  32. Mark commented on May 7


    PE ratios contract in BOTH deflationary AND inflationary environments. Crestmont’s research showed this clearly. Their research also shows that “interest rate stability” is a figment of imagination. There is no such thing for any extended period of time. Interest rates are much more volatile than assumed.

    The Goldilock’s scenario of extended periods of low inflation engineered by the Fed giving rise to an extended periods of high valuations and meaningful returns is a real as the fairy tale.

  33. Dennis Chan commented on May 7


    Right on. PE ratio depends on mainly two things, inflation and growth prospect. Right now, inflation is quite low and is expected to remain low. The earning growth prospect for US companies are quite good and are expected to get better. Given these two conditions, it is really hard to understand those that argue that we must have a mean reversion as if that is the law of nature akin to E=MC2. Now, you may disagree with that assessment, then by all means go short or stay out of the market. I am long and getting longer.

  34. B commented on May 7

    The only reason I brought up your name is I couldn’t understand any other reason someone would make such a foolish statement as Shanghai has more skyscrapers than New York. Sounded like a prideful statement. And we all should feel that for our heritage. I guess I was wrong and you were using sound economic analysis for your statements. Personally, to me there is somewhat of a silliness IMO to use that as a basis for economic strength. Especially given the constant chorus by the IMF to get China to stop the rampant speculation in real estate before crisis is created. 30% of all GDP is real estate driven in China. Or so estimates are since any real statistics out of China are about as accurate as those given by the Soviet Union.

    Extract from a recent E&Y white paper. Btw, NPL is nonperforming loans.

    The 2006 report does point out though that almost every country covered in the 2004 edition of the report—with the notable exception of China—has managed to reduce its “legacy NPLs” (loans made before 1997). There are signs even in China that transaction activity may be on the rise.

    However, considering Ernst & Young’s own conservative estimate of the actual depth of China’s total NPL exposure—at US$900 billion, substantially more than any other country in the report—and the large numbers of legacy (pre–1997) loans still to resolve, China’s NPL problems appear far from over. As reported, China’s overheated property markets are certain to produce fresh NPLs in coming years.

    Uh……..$900 billion conservatively? Produce more in coming years? Can you say state driven production quotas? Tanks. Corn. Oh, and now real estate. So, approximately one third of China’s GDP in nonperforming loans with more to come? That number is very low from what I have seen. So, in essence the economy is built on a Ponzi scheme. That is, unless you believe nonperforming loans can be turned into performing loans with some type of magic wand. So, that would be equivalently, a $4 trillion right off by US banks? Btw, notice, this has nothing to do with pre-1997 NPLs. A house of cards. So, effectively, most of those skyscrapers are not being paid for. But, to your point, there sure are alot more than in New York. I guess the difference is the ones in New York must be built based on sound economics backed by a healthy market driven bond, debt and banking market.

    I don’t know when and how………but the commies are in for a capitalist lesson. And, it has the potential of creating a socioeconomic crisis that could create civil unrest of massive proportions. Of course, I’m sure this is all bullshit and you are right.

  35. Mark commented on May 7


    Then you are banking on PE expansion from historically high levels and historically high earnings levels as well to give you positive returns in your portfolio. If that sounds reasonable to you, that’s okay with me. It isn’t part of my investment strategy or outlook but that’s what makes a market.

  36. Dennis Chan commented on May 7


    I am certainly not counting on both PE and earnings expansions. I am banking on only earnings expansion and relatively stable PE.

  37. Zephyr commented on May 7


    I realize that P/E ratios can rise or fall relative to interest rates and inflation. My comments are directed toward the idea of selecting the appropriate P/E benchmark to use when evaluating the observed P/E ratio.

    Using a single number as the benchmark for comparison is much too simplistic. It is far better to use a scale that incorporates the inflation and interest rate environment. The value of earnings and the appropriate cap rate must change as interest rates change. Accordingly, when the long-term risk-free rate is around 10% the P/E is appropriately lower than when the risk-free rate is around 5%… (all else being equal).

    So if the long-term average P/E is 14, the appropriate benchmark should be adjusted up or down from 14 based on the prevailing interest rate environment at the time of comparison. The actual observed market P/E should be compared to this adjusted benchmark.

    Using a single P/E benchmark to apply in all times and economic conditions is just too simplistic… of course, any use of P/E ratios is just a simplistic quick test, and one must look at far more than P/E ratios.

  38. Mark commented on May 8


    I understand what you are saying and I have heard E.Garzarelli make the same point. However, I find that to be a very short term balancing calculus since rates are more volatile than we all seem to assume. For some reason the only comparison that I can think of is “moral relativity”. Perhaps this is “PE relativity”, not to be disparaging.

  39. Zephyr commented on May 8

    Mark, this is a math relativity, not a moral relativity. Those who ignore the math do so at their own peril.

  40. ravi commented on Jun 28

    hai all,

    I agree with Mauldin, who concludes his 5/5/06 letter with this bon mot:

    “Call me a bear, but I continue to believe we are going to get a chance to buy this market at a much lower level than today’s close

    happened to read the above article on 28th June 2006. Has’nt what has been said come true.stocks are definitely cheaper than they were on 6th May 2006( especially India, where i am from).

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