Yet another terrific chart from the fine econ wonks at the St Louis Fed:
Source:
Is All That Talk Just Noise?
St Louis Fed
August 2006
http://research.stlouisfed.org/publications/mt/20060801/mtpub.pdf
S&P 500 versus P/E
August 17, 2006 6:03pm by Barry Ritholtz
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Offset by 8 years and they correlate strongly. Scary strong but I suspect coincidence. I know I’m dumber than the worst poster on their worst day so hold my hand here. I see every possible positive and negative association here.
Looks like a recession danger zone.
Barry — what do you make of the PE compression during this bull market run since 2003? According to Birinyi, this is apparently the first time that this has occurred (not to be confused with PE compression over the duration of a secular bear market).
Sure Barry. You just made that chart up. But what about cash held in drug lord accounts in Columbia and Mexico?
RB- PE compression is to me the calling card of a Secular Bear. So countertrend rally or not, not surprising at all to me, even if it hasn’t happened before (according to Birinyi).
B- That’s hilarious!
Larry,
Apologies for being blunt but your Ritholtz Research website is a confusing mess. The entries under Alerts are not sorted by date. Why do we have to open PDF files to view the various communications?
Did you have a professional designer do this? If yes then start looking for someone who can bring to your site a deep knowledge of user interface design.
Best regards,
Drew Yallop
~~~
BR
Its user definable — you can sort the posts by date, name, or hit count.
click on the top of any word
the composite index line looks more like a puppet string from ’03- to- ’06
Who the hell is Larry?
per Drew Yallop:
“Larry,
Apologies for being blunt but your Ritholtz Research website is a confusing mess.”
And on top of all of that, Barry apparently changed his name to Larry? What an outrage! lol
A clever music video
Remake of Every Breath you take (Bernanke)
http://www.youtube.com/watch?v=ipJTqCbETog
BBB,
I take a long term view on the subscription. Patience will be rewarded. OT, had a good wine lately? Any ideas on inflation, truck prices? Got gold? Look at those PE’s on the HB’s! Now there’s an opportunity, right B?
Yeah Larry,
You and your twin brother Barry really confuse me. It’s terrible, I have only made twice the price of the subscription from the market calls you have made. I’m glad that you sent me those e mails because I have so much trouble with that PDF thing. I’m also pretty unhappy that you didn’t pull your ear lobe on Kudlow’s show today like you promised. Oh well, I guess I’ll just have to settle for making money. Thanks again.
I think there might be a piece I am not understanding. Aren’t the composite index and the “P” in “P/E” basically the same thing? If so, then the two lines would rise and fall in parallel any time that E was basically unchanging. And a gap would open up between P/E below and composite index (P) if the E rose. Which is what has happened the past few years.
I trust the 10 year trailing earnings chart more than this chart.
PE fell low last 2 yrs because of record high earning from cashing out record equity and negative savings rates.
You must average 10yrs of earnings in my opinion to get a good picture of the companies’ health.
By the way… Please explain to me why the hell companies are issuing DEBT to pay DIVIDENDS?? The WSJ had an article about this today.
If I’m a long term holder of any stock, why is the CEO going to take debt out on my asset to give me cash in my pocket?? If I needed cash I would sell the stock! He’s just deteriorating the fundamentals of the company to juice up the stock price so they can liquidate their options. Management is killing the long term holder!
My pet peeve
Steven,
That’s business as usual in the homebuilding sector. They use debt to pay dividends and buy back stock.
Sorry, oops, just wondering: is this news? :-)
So the latest thesis being memed around is that the market goes up due primarily to P/E expansion, and down, primarily due to P/E compression. All neatly laid out for $30 from Easterling’s book [the last 1/3 which is a shameless pitch for why Hedge funds are so important…]
Neat theory, doesnt do much to explain the above graph that shows falliing P/E ratio’s [yes off historic highs, I understand] and concommitent rising S/P 500 for 3.5 years.
Looks like the reversion to the mean has not happened yet, all the S&P did was pull back to the upward sloping trend line … when will we get the break below it? Also, all the “E” is from the oil/energy co’s … everyone else is dead in the water … yet the market refuses to fall?
What gives?
“Aren’t the composite index and the “P” in “P/E” basically the same thing? If so, then the two lines would rise and fall in parallel any time that E was basically unchanging. And a gap would open up between P/E below and composite index (P) if the E rose. Which is what has happened the past few years.” [kevin_r]
I think that’s right. Whenever earnings change, the lines will diverge, regardless of what happens to prices. When earnings go up, as they have in recent years, the slope of the P/E line must decrease in comparison with that of the P line. What’s significant is that P & P/E are moving in different directions (one is going up, the other down). Earnings have been strong, so stock prices have been going up. However, interest rates have been rising, and that has counteracted the effect of rising earnings on stock prices, to some extent.
In the recession of 2001, the effect of decreasing earnings on stock prices was offset by decreasing interest rates (resulting in increasing P/E). However, the big U.S. trade deficit may limit our ability to lower interest rates during the next earnings slowdown…
This PE is on reported earnings. If it were on operating earnings it would be a couple of points lower.
But it makes a good point about Administration policy.
They claim their tax policy lowered the cost of capital and drives the current investment “boom”. But the theory is that lower taxes lead to a higher PE and that generates a lower cost of capital. But where is the higher PE that they claim is lowering the cost of capital?
I do not see it. Do you?
A novice here, so forgive any questionable associations, but it would seem that the overriding question is the sustainability of corporate earnings. The divergence between the Composite Index and PE ratio started in ’03. While the Fed Funds and Prime Rate declined significantly from ’01 to ’02, a significant drop in mortgage rates wasn’t seen until a year later. The insatiable consumer demand since ’03, driven by extremely cheap funds and windfall liquidity from real estate has been the principal driver of corporate profits. Corporations have benefitted from lax credit markets since ’03 and relatively cheap funds which have spurred corporate investments (reference 450+ basis point spread between Fed Funds rate and Corporate Aaa Bonds in ’03 which has declined to sub 100 basis point spread in ’06), but their absolute borrowing costs have not declined to aid corporate profits. Strong consumer demand has led to a reluctance on the part of corporations to pass along higher material, energy and production costs; however, if consumer demand wanes due to a softening real estate market, higher borrowing and energy costs and corporations start passing along higher production costs in an effort to maintain corporate profits, it would seem that accelerated inflation will result. The accelerated inflation likely leading to higher borrowing costs, weakened consumer demand and slumping corporate profits.
Consumer Sentiment sharply down. From EconoDay:
“Actual 78.7
Consensus 83.8
Consensus Range 80.0 to 84.0
Previous 83.0
Highlights
In a new wrinkle for the slowdown outlook, the University of Michigan’s consumer sentiment index fell sharply from a July reading of 84.7 to 78.7 — a mid-month reading that would be the lowest full month reading of the year. In especially bad news, the decline was centered in expectations (64.5 Aug. vs. 72.5 July), not current conditions (100.8 vs. 103.5). A widening spread between expectations and conditions, up more than 5 points in the month to 36.3, hints at further declines in overall readings. Before today’s report, the Michigan and Conference Board readings, hit hard in the spring by the year’s initial gas spike, had been rebounding over the last several months.
In more bad news, high gas prices and new highs in oil prices pushed 12-month inflation expectations suddenly and sharply higher, up 1 full percentage at mid-month to 4.2 percent.
Though retail trade data jump sharply and surprisingly in July, other indications, both from weekly chain-store reports and from chain stores themselves, point to soft conditions. Bonds firmed and the dollar eased in reaction to the Michigan report. ”
I was especially intrested in her (Ms. Tanier’s) comment regarding retail data. I am in the business and thought the recent trade data was erroneous and that store reports were more reflective of what was going on. I see that she has the same suspicions. Barry has talked about the NRF figures as being laughable but I had always thought the ICSC data solid.
Steven,
The reason a firm will issue debt to pay a dividend isnt all that different than the logic for an LBO.
As the asset (the firm) generates steady earnings, it can afford to issue debt to pay a one time dividend.
The firm can’t make good use of the cash it has so it returns it to shareholders. It actually is the right move for shareholders under a number of scenarios. If the firm could generate superior economic returns on its assets, then it would be better off holding onto the cash and investing in the firm. That might not be the case here. Better that management realizes this than squanders the the money on pointless investments like so many firms do.
The right long-term thing to do with the money IS return it to you. So you can invest it other places that will have better returns.
BTW – I don’t get your poing about selling shares being equivalent to receiving the dividend. Completely different.
NOTE: I encourage debate and even allow a lot of room for commenters who may potentially trolls.
When it comes to criticism about RR&A, I will tolerate it only when accompanied by a real email/IP address.
Today I deleted a comment that I suspected was not real — it had a bogus email and no prior posts under that IP address. If I was incorrect please email me
Just an FYI
Hank–
With all due respect, yes markets are forward looking, the problem is that analysts are incapable of accurately estimating earnings. Perhaps the best source on this to read up on is David Dreman.
Other folks–
The majority of market gains in the past have been due to P/E expansion. This should be intuitively obvious, as there is a divergence in the growth of ‘E’ v. ‘P’ in bull markets. Yes ‘E’ goes up in good times, but ‘P’ goes higher.
Ol’ George Soros in his book “The Alchemy of Finance” [a must NOT read btw] actually takes credit for “discovering” that we, with our lizard brains in control, see earnings rising, and so we extropolate them to the moon, hence we are willing to pay more for those “future earnings” and ‘P’ goes higher and higher.
That’s the “greed” part of “Fear and Greed”. Soros gave it a fancy name–‘reflexivity’– which basically just explains what I said. Eventually there is reversion to the mean, often an over shoot on the down side.
History has shown there has been no SECULAR bull market unless P/E’s have contracted to 10-12 or less [trailing]. What is perplexing is the compression is occuring substantially now within an at least arguably cyclical bull market since 2003. Either history repeats itself, and we pull back on the ‘P’ soon before the next long secular bull run, or ‘it’s different this time”
Well, I would say the opposite: if the market goes up above trends this usually causes P/E expansion, as stocks gets relatively scarcer. And viceversa.
Rather less, usually they bottom at 7-8.
It is not different this time, but because of an unsustainable special case it looks different for a while, my usual quote:
http:/WWW.beearly.com/pdfFiles/PIMCO092005.pdf
http://WWW.PIMCO.com/LeftNav/Late+Breaking+Commentary/FF/2005/FF+September+2005.htm
Note, this in 2000. Presumably now the P/E should be around 10. Paraphrasing “Casablanca”:
”It would take a down cycle to get stocks out of ridiculous valuations, and the FOMC have outlawed down cycles.”
How ridiculous are valuations right now? Well, check out IBM, Cisco, J&J and P&G:
http://finance.Yahoo.com/q/bc?s=IBM&t=my&l=off&z=l&q=l
http://finance.Yahoo.com/q/bc?s=CSCO&t=my&l=off&z=l&q=l
http://finance.Yahoo.com/q/bc?s=JNJ&t=my&l=off&z=l&q=l
http://finance.Yahoo.com/q/bc?s=PG&t=my&l=off&z=l&q=l
IBM and Cisco at the same price as in 1999, when they were on their way to a tripling, and J&J and P&G going up almost exponentially with only short dips in 2000?
Note that both IBM and Cisco are have-beens, and J&J and P&G have been riding the Buffett wave of brands that appeal to increasingly prosperous middle class baby boomers, and right now we are running out of baby boomers and the incomes that are increasing are those of the top 1%, not the middle class.
But if the Greenspan Put means that asset values are not allowed to go down without a huge rate cut to get them back up, the sky is the limit.
Of course the Greenspan Put is highly inflationary, and it has indeed caused high price and wage inflation in China and India so far.
As India and China have been integrated with the Greater American Co-Prosperity Sphere they have brought with them a lot of spare capacity, and a highly inflationary monetary policy has been sustainable. There are now many signs that India and China are at full capacity, including wage inflation running at 10-30%.
Now the question is whether the Greenspan Put becomes a Bernanke Put or the Volcker Squeeze becomes the Bernanke Squeeze.
Blissex– i think [?] we agree mostly. The lowest trailing P/E I have seen is 11 for a secular bull beginning, so I think you’re numbers are a tad too dire.
But the fact remains, bull markets go up–meaning stocks cost more BOTH in absolute price as well as their price relative to their earnings growth–this is a fact. 1982– P/E of about 10, 2000, P/E of 30.
My last point was meant to just say I have no crystal ball, however my portfolio is position as ‘it wont be different this time either’. Just perplexed about that chart form 2003-2006, that’s all.
Yes, just arguing for the sake of clarification…
Nahhh. Hey, as my father used to say a long time ago, the ”natural” thing is to have P/E at around 12, and that should be the average of trend. A P/E of 12 means that accounting earnings are around 8% of capital invested, and lower than this one switches into other assets.
Unless of course growth is happening, and then perhaps there might be a case to see market P/Es grow as far as 18-20.
Conversely when growth is bad a P/E of 7-8 means a junk-style earnings of 15% are needed to entice an investor to abandon safer assets.
BTW, interesting articles on the Nifty Fifty and their P/Es in the 1970s :-)
http://www.dows.com/Publications/High_PEs.htm
http://www.fool.co.uk/qualiport/2005/qualiport050517.htm
«At its peak in 1972, the Nifty Fifty had a price to earnings (P/E) ratio of 41.9 — more than twice the 18.9 offered by the main US index, the S&P 500.»
Note that 19 P/E for the SP500 in a time of extraordinary prosperity.
I have been lucky with my web searching and here are some arresting graphs of the S&P 500 over several decades, one all the way back to 1925, compared with where it would have been had the P/Es had been 10, 15 and 20:
http://www.gold-eagle.com/editorials_02/jmiller092402.html
This guy BTW puts the ”normal” P/E value at 15, which I think is a bit too high, but still defensible.
Seems right, and one could arrange the same data in one of these ways:
* P/E and P as in this graph.
* P and E.
* P, P/E and E.
* P/E and E.
Of these I think the most informative would be perhaps E (deflated by some index, like GDP deflator) and P/E.
Or perhaps: E changes and P/E.
Because it is interesting to see if growing/shrinking E does related to P/E. After all the theory is that people are buying earnings, not shares, and it is an idea that has some merit; except that ”earnings” are virtual, and it would be more interesting to see dividends or total returns instead of E.
Conversely people buy-and-hold at P/Es higher than 10 are mad. Sure one can make money buying high, but only by selling higher, that is the ”greater fool” strategy, that is momentum or trend investing, and then one is really timing the market, and that can work, for some.
Interesting perspectives by a commenter in another good blog:
http://economistsview.typepad.com/economistsview/2006/08/robert_shiller_.html
6%? Thats a P/E of 16 cash in hand, not ”earnings”.
Of course, like during the dot.com boom, I just ”don’t get it” :-).
A wealthy gave me the advice of of the rule of 21. When the PE plus the prime rate exceed 21 time to get out.