I get all sorts of email. Some of it, I simply do not know what to do with. I respond to polite requests, I look at suggested specific links. Some I simply delete.
Then there’s this sort of thing: I never know what to do with half formed concepts or unsupported arguments. These tend to raise more questions than they answer.
Consider the following interesting analysis (I responded to the author, but never heard back from them).
Based on this week’s Chart of the Day, this person concluded:
"Wall Street uses 12-month forward EPS estimates to calculate P/E ratios. The chart below is based on 12-month trailing EPS, which inflates the P/E ratio. Based on 12-month forward EPS, the post-WW II P/E ratio range for the S&P 500 Index has been 10x to 20x, excluding the 1970s nadir ~8x and the 1996-2000 bubble range of 20x to 26x.
Regardless of the EPS figure used, the chart’s message is clear: today’s P/E ratio is NOT excessive…based on 1980-2006 performance, it is about average with plenty of “head room” for P/E expansion.
Also, the “steep downtrend” between the dashed red & green parallel lines in chart below counts as five Elliott Waves down…followed by a turn UP. THAT is extremely BULLish !!! Suggests the potential for P/E ratio expansion for years to come…..that would fuel an incredible BULL market.
>
I find this sort of thing quite intriguing. The letter touches upon some fascinating points — issues I am very interested in. But it fails to esolve them satisfactorily. Indeed, it raises more questions than it answers.
Here’s the first dozen or so that popped into my head:
1. Why does a trailing P/E (price/actual earnings) "inflate the P/E ratio?" Isn’t genuine data — what the earnings actually were, rather than what they were forecast to be — more reliable than analyst consensus of earnings?
2. Do P/E ratios have any predictive power in forecasting the stock market’s subsequent returns? What is the basis for that belief? What specific P/E ratios have historically triggered a buy decision with a demonstrated ability of out-performance in the past?
3. The 1980-2006 period includes the longest bull market on record (1982-2000), thus skewing the P/E ratio upwards. How does the P/E look for full period 1950-2006 (inclusive of highs and lows)? What does the 1906-2006 range reveal? How about 1966-1982?
4. Why do you think the market was in a bubble from 1996-2000? Wouldn’t late 1999 to 2000 be a more accurate range for the tech bubble?
5. What is your basis for saying the dashed line is an Elliot 5 count? If it is, what is the historical forecasting record of using Elliot Wave 5 counts of P/Es as a buy indicator?
6. What has past P/E compression and expansion cycles looked like? Is this one similar or different to prior oscillations? Why?
7. "NOT excessive P/Es" (emailer’s phrase) — what are they? What does that mean for subsequent market performance? Are "NOT excessive" P/Es a sufficient basis for making an investment decision? Is additional confirmation needed for a buy or sell signal?
8. Forward P/Es are consensus opinions. How accurate have they been at major turning points (tops and bottoms)?
9. In 1999 and 2000, the S&P500 P/E ranged from 25-30; Why did it shoot up to 50 two years after the bubble popped?
10. Is this actually a trailing P/E? (The chart is silent on this)
11. The 1982 Bull Market began at a P/E of 7. Will the next Bull market start from a higher, lower or the same P/E? Why?
12. That’s a very awkwardly drawn channel, quite narrow, and intersecting the prior channel. What if I drew the channel differently? See below for a valid trend channnel.
Does that change your view of the "headroom?
~~~
About this original email: The idea behind this exercise isn’t to say the the original emailer was wrong. For all we know, the author may be absolutely correct about their forecasted "Incredible Bull market."
But how can we tell? Lots of conclusions and unsupported assertions are built in — highly subjective — but there was no persuasive proof. These various questions point to that.
One of the reasons I have long been a fan of quantititative,
technical and cycle based analysis is the ability to make an objective
— rather than a subjective, squishy analysis. That’s been a big problem with much of what passes for pattern based technicals, too.
That’s also the reason I recommended David R. Aronson’s tome, Evidence-Based Technical Analysis.
I very much like the idea of applying a more rigorous scientific method
of statistical analysis in generating less subjective trading signals.
You really took that one apart Barry. I was actually looking at some charts of similar precepts.
I have a chart saved on my computer from Decisionpoint.com although I couldn’t find it on their site.
Looking over a much broader scale historical P/Es for the S&P more or less fell between the 10-20 range. Minyanville was more like 10-22.
Even so there were many a time that the P/E hit a low of nearly 10 times earnings (and after a heavy blow) while the market nevertheless dragged the bear on for sometimes 6-8 years following.
Examples:
Following 1929 PE of 10 – to 5 – to 10 – back to 5.
Between 1964-80 the ratio pushed about 13 three times before diving below 10.
In 1987 the market retreated after hitting a ratio of 20 and didn’t return till 1998.
sorry, in first example the 1929 ratio peaked at 20.
The last rise in the PE in 2000 reflected the Fed flooding the system with reserves after 9/11 and withdrawing the excess reserves after the Fed saw the excess reserves were not needed.
Generally returns over a decade reflect the pe at the start of the period. If the pe is high returns are low and vice versa. This is a highly reliable rule even if it of no help in telling you what the market will do over 6 to 12 months.
Generally it does not matter if you use forward or trailing PEs. But when it does matter it implies that trailing is better.
The best example is 1987. In 1987 people expected a 30% rise in eps in 1988. So if you used trailing earnings the market looked extremely expensive and dangerous.
But if you used forward earnings the market was fairly valued and there was no reason to worry about the market. The 1987 crash clearly demonstrated that trailing PE was superior.
Finally, this Pe is on reported earnings and you might prefer to use operating earnings after about 1990. This turns the peak Pe in this chart from 50 to 30.
I have pe data going back to 1880 and the range is from under 10 to over 20 with an average of about 15. But the average is a meaningless figure because there is no central tendency for the PE to converge on the average — it is just as likely to be 12 or 18 as 15 at any point in time.
bottom line were near a cylical peak ine arnings and when thats apparant to all we should start discounting it
R –if you can be right on the direction of PE moves you have about a 90% probability of being right on the direction of the market.
But the relationship between changes in the market and changes in EPS is almost perfectly random so even if you are perfectly right about future earnings growth it is of little or no help in telling you the direction of the market.
P/E is a bad proxy for NOI discounted cash flow analysis. Rising P/E from 82 on mostly reflects the drop in interest rates and thus a lower disccount rate.
P/E also varies across the cycle with earnings. According to Hussman, P/E tends to be compressed at the top of the cycle as earnings and margins are peaking because people expect earnings to revert to the norm. The same logic suggests that P/E expansion occurs in coming out of recession in anticipation of recessionary earnings expansion.
At the end of the day, the long term, net cash flow from equities (growth in earnings, capital gain + dividends), discounted at the going treasury rate plus a risk premium, should be the determining factor. With short term treasuries yielding 5+ %, are equities priced to deliver 5 % + 2-3 % risk premium.
What about the potential capital loss if earnings fall or the economy enters a recession of browns out. In that case, the current P/E might expand rapidly and be accompanied by a powerful capital loss.
With 10 year treasuries yielding ~4.5 pct, there is logic that the current P/E is not excessive. The devil is in the detail. Is the inverted yield curve signalling recession, will earnings decline, etc.
Can we compare the stock market of 1987 to the present? At that time, there was no plunge protection team in place for the market or the housing industry, for that matter. What was the real reason why Easy Al never wanted the hedge funds to be investigated nor regulated like Warren Buffet wanted? I think Buffet has started buying foreign stocks because he feels the dollar will GRADUALLY decline due to “market forces”, lol.
Why can’t we concentrate on stock trading rather than guessing the market?
This has been a bull market for SP500 but a severe bear market (50% correction) for home builders. Stocks like MOT, COMS are coming down. RIMM, GOOG, BBY, SBUX are starting following suit.
I have put options on all these issues.
Having said that I recently added some qqqq puts.
I think toon is correct.
Also pe when applied to across the board markets seems to be vague. If one sector of a market rises and another goes down they might have a negating effect on the ratio. Yet as an investor I am much more concerned with keeping my funds and getting what I consider to be high returns. So I want to be corectly on a sectors price action. I suspect that only in the most general way will it help me invest. Sure a rising tide lifts all boats but that is a flawed analogy. It seems to me when we look at the world at any one given time, that there are markets that are going up and others down. I am much more interested in picking a winning market and riding it as long as possible. I also have preferences for how the markets behave when I invest in them. For most situations I prefer one that goes up relatively steadily and as strongly as possible. Of course others might prefer greater volatility for their trading style.
I am also willing to concede that one can go beyond that, we can invert the chart, and bet on a decending market. Over priced investments tend to be bad. But what I mean by overpriced is that there are likely to be more sellers in the future than buyers. I do prefer aspects of so called “value investing” but the most important aspect to me is what are the probabilities that I am not only going to make money on this bet but that it is likley to be sizable, with a msall chance of loosing money over a designated period of time.
If a company has great cash flow, increasing earnings, and looks good for increasing revenue, then a low pe is a tell, but without the former the later might not carry any weight. Things simply could be getting worse and the owners have dumped the stock and the earnings numbers are off.
So I think the whole market pe thing is overblown. It really has to be looked at in the context of financial reality, and crowd psychology.
Later
Human nature is, has and always will trend toward extremes. In 2000 we saw extreme bullishness. Since 2002 we have seen an incredible expansion of the money supply and earnings growth. So what has been accomplished? The S&P is still underwater by roughly 10%, the Nasdaq by 50%, the Dow has made a nominal new high of about 5% (the same as 1973). We have yet to see the swing to extreme bearishness that has always followed secular bull markets. We will eventually unless human nature has changed. I’m betting that this time won’t be different. When the market has finally wiped out all the bullish fervor and nobody ever wants to own stocks again and P/E valuations are depressed to similar levels as dividend yields then and only then will we give birth to another secular bull market. I suspect the same will be true for the real estate market.
conclusion? what worked before doesn’t mean it will work now. What seems so logical, housing crash, ect, many times if not most just doesn’t work. remember everyone putting up charts that showed that the market floundered every time the Fed stopped raising rates? Well…since then the indexes are on a tear that matches few in the last twenty years. At the time, it seemed so logical…
the market has a dynamic that is its own. It does what it wants to do. Forget about these anecdotal charts. They are all very interesting and generate a lot of thought but they are worthless. Follow price.
Does anyone have a chart showing the difference between the bond yield and the stock yield? I’d pay more attention to such data than just P/E alone.
What’s always been difficult for me to understand is how hard it seems to be for many to understand that severe contractions of the market P/E ratio have caught other investors in the same denial that the contractions could ever occur.
I have no problem understanding they can expand… why’s it so hard to understand they can contract to even a 7,8 or 9 P/E? Is there some theoretical religiosity that would somehow deny the market of ever expressing a P/E under 12 again?
Is it possible that willfulness alone is enough to cause P/Es to expand?
It’s not like the market collapsed from P/Es of maybe 15-18 to those of 9-12 or even lower because investors had suddenly said: “Gosh, now that we think P/Es will contract, let’s get out.”
What I think happens is that investors, for whatever reason known only to them, withdraw their investment proxies from money managers in all forms. They do this at least temporarily as a function of their concerns for their own financial future.
The equities the investor manages for himself, he’ll instantaneously apply a more circumspect valuation related to earnings and prices he’s willing to pay will demand lower P/Es.
Money managers (brokers, money managers, mutual fund managers, etc.) will react to the widespread higher demands for R.O.E. and will also participate in the lowering of market P/Es.
I can’t back this up with any tangible statistics, but my guess is that we have a 1:3 chance within 5 years of experiencing a P/E under 12. It’s not so much the 12 that concerns me even though on current earnings it’d represent at least a 20-30% drop in the market. The market can avoid a drop, even with a 12 P/E, given that earnings improve fast enough for the market to hold steady even with P/E contraction to 12.
It’s the possibility of a 6-9 happening sooner than earnings have time to expand to counteract it, and worse, were it to be expressed with an actual halt in earnings growth, or still worse, with a contraction in earnings as well.
The federal reserve bank of Boston is publishing a very comprehensive analysis on historical Pe’s http://www.bos.frb.org
In a nutshell the average historical Pe is around 15 The risk premium between stocks and long term bond yield is as well an element of consideration, but again what if the long term yield curve has been manipulated and DOES NOT reflect the real bond values ? This may be the case as UBS HSBC and other primary dealers are currently under the Fed investigation as they would have immobilised much more than their fair shares of the bond market with effect of driving the prices up and lowering the yields. It makes the risk premium assessment of stocks against long term yield a little precarious exercise.
After all that waling and knashing of teeth on this blogsite for over a year, I see that the major homebuilders like Toll Bros, Lennar, Ryland, and Pulte have slowly climbed out of the toilet, and even after the correction at the end of this past week, are still above their 50 and 200 day moving averages, and other homebuilders are close. You just can’t ignore the technicals of the market even tho the fundamentals look like crapola, or you could be selling apples from a cart.
~~~
BR: Agreed. Back in September, we noted: “So at this point it looks like the group could possibly be setting up for a counter trend rally that may provide an intermediate term opportunity to capture some positive return.”
That conclusion proved accurate. You can see the complete subscription-only analysis is here
P/E’s are a useful construct when compared with the cost of capital or borrowing of corporations. When the earnings yield (i.e., the inverse of the P/E) of a company is higher than the return that it can receive on cash, it may make economic sense for that company to repurchase shares (to capture that earnings yield) rather than leave spare cash on deposit.
In some circumstances,it may make sense for companies to borrow to buy back shares, if borrowing rates are lower than the earnings yield.
Both of the above circumstances currently apply, which is perhaps one of the reasons why corporate buybacks are so prevalent at the moment. This, in turn, would support the original emailer’s contention that current valuations are not particularly expensive, particularly in comparison to the valuation of fixed income securities.
For a graphical comparison of recent earnings yields compared with those in 1987,
check the url below.
http://macro-man.blogspot.com/2006/12/is-dollar-about-to-undermine-stock.html
The returns achieved by the market/stocks is based on future expectations. This is why companies that are losing money can generate strong market returns if they beat expectations, even if only for the short run. The point of this?
As of 12/7/2006, 483 (97%) of S&P 500 companies have reported earnings. The YOY 3rd quarter earnings growth is running at 19%. This is the 8th straight quarter S&P 500 companies have exceeded First Call consensus estimates. Analyst are projecting 9+% earnings growth for the 4th quarter..I think they are too low.
How many companies have beat earnings estimates versus the average analyst estimate?
Positive surprises 206 (43%)
Positive reports 138 (29%)
On target 48 (10%)
Negative reports 46 (10%)
Negative surprises 45 (9%)
Additionally, a smaller percentage (versus 4Q 2005) of companies are giving 4th quarter earnings previews that are lower than last year.
If one looks at the trading range of the S&P 500, it is trading -1.0 S.D. from its 15-year average.
Lastly, the markets will not correct just because they are overvalued and they will not go up just because they are undervalued. Some external “unanticipated” event will move the market in one direction or the other. Looking out 12-months, I believe the market is fairly valued (certainly not overvalued) and the odds are this market moves higher as it climbs the “extended bull” wall of worry.
You just can’t ignore the technicals of the market even tho the fundamentals look like crapola,
TA without FA is DOA
Has cap ex spending returned? No. If it doesn’t and Bernanke wants nominal growth, could you see homebuilders return to glory? Maybe. All we’ve seen from CEO’s is backdating of stock options for which they all should go to jail and selling by them in unconscionable amounts.This start to the 21st century economic period has been the strangest in my lifetime.
Greed – my friends, is what makes PE ratios go up…Let me add two other factors to that…
1. Liquidity
2. An undicuseed ‘generational dynamic’…
PART #1
Each ‘generation’ will bring in a new set of ‘hotshot’ money managers who will feel invincible until they become, well, ‘vincible’…Maybe they start with some sort of blueprint or fundamentals, but eventually those will get tossed away as they either
1. Beat up on the rest and assume an air of cockiness.
2. Fall behind and are forced to play ‘catch up’ or get sent to the scrap heap. (Like a football team with a ‘run oriented’ style when it finds itslef down by more than 2 touchdowns and the clock ticking).
PART #2
If there is enough liquidity around (which it would easy to make a case for ‘globally’ in the present environment), all will be given adequate enough rope to hand themselves with.
PART #3
It all ends bad…The PE’s eventually reach the point of unsustainability and nobody has anywhere to turn.
The actual NUMBER of the PE is irrelevant (although interesting and anecdotal in chart form)…
Commenting on the chart itself. The visual that strikes me (when interpreted with the above statements in mind) is the following:
The dynamic of the 70’s was ‘hyper inflation’ (or, in any case – more exaggerated vs. the norm)…The effect? An eventual withdrawl of liquidity and lower aggregate PE’s (less money to f*** around with)…When interest rates began pulling back in the early 80’s, liquidity re-emerged (and has still remained intact – especially with globalization and expansion)…The punch bowl will not be taken away until the global aggregate infrastructure has swelled to it’s service ‘leveling out’ point (or, at least perceived to)…Whether it should or not (based on PE theology) is irrelevant…The way I see globalization, it still seems to me like there is infrastructure work to be done…
Therefore, there will probably be…
1. A demand for liquidity
2. A new generation of kids willing to borrow and throw money at it until they get rich, hurt, or left in the dust.
3. Room for a move towards rising PE (ala late 90’s)…
To look at the situation from a ‘chartists’ perspective (which I’m not)…I’m wondering if the ‘rising room’ from here might find it’s Waterloo at what would be a REVERSE HEAD & SHOULDER when PE’s were, say, to get back to around the 22-23 level (which was hard to exactly determine based on the graphic.
Chet
So many people are gleeful over the S&P earnings growth and companies beating estimates, but I wonder how much of that ‘growth’ comes from accounting gimmicks like Bonus Depereciation method.
What that S&P 50 P/E chart does demonstrate is that the much-touted “Reagan Revolution” was a total fraud, that “junk bonds”, “small government”, “hedge funds”, “pump and dump” and “tax cuts (for the wealthy)” only served to more than double the price tag of obtaining an equivalent return on investment earnings. For which “Contract-on-Americans” was well-named, and which Y2K was the final sot-fest wake up call.
Or, inversely, to 2000, alpha got dearer to buy, until Republicans stole into office. 9/11 was their starter’s gun for flat-out fiat currency “print your way to success” expansionism, inflating earnings after 2001, simply because the Neo’s wished them to be.
Like to see P/E charts in pre-Nixon dollars.
Then, a “bullish” breakout may be nothing of the kind, rather, desparate momentum plays chasing falling real earnings. All that IRA has to go somewhere; real estate ain’t it.
So what “is” a “bull” market, really? Fiat?
Friday over a billion shares traded in a range of $3. Churn has become a maelstrom.
Any news, anything, will be played by the pundits as “bullish”, and off we go to the races again, while gold goes up in synch.
Ehh? Gold up and P/E up, unlinked?
C’est le conte d’un taureau, ne signifiant rien.
JSL.
Taking depreciation charges would actually make earnings look worse. Looking at cash flow though, first call 2006 consensus is $125.08 versus last year’s $112.45. Additionally, S&P reports $431 billion in stock buybacks over the last 12-months. I wish it were dividend increases since dividend payments are potentially a longer term commitment by the company and might be a better forward indicator.
In November, S&P reported “stock buyback activity continues to grow at a record pace, surging 35% from that of the third quarter of 2005 and 140% from that of the third quarter of 2004. In US dollar terms, stock buybacks in the S&P 500 were $110 billion during the third quarter, slightly less than the record set during the second quarter at $117 billion. It was the twelfth consecutive quarter of strong growth (+20%) in buybacks for the index. For the 12-month period, total buybacks are at a record $431 billion.
PE 15 – 18 for SP00 is very high number (in this environment).
At the top home builders had a PE of 8 and now they have a PE of 5!
MSFT has a PE 22, SBUX 40, RIMM 40, MOT 15.
MOT is dropping like a stone.
We may see MSFT back to 20 in 2007. I am looking for an entry point to short it.
David,
Appreciate your comments but they make me wonder even more:
1) The bonus depreciation method I mentioned would depress the earnings in the beginning year but would inflate earnings in the proceeding years. The method may be claimed for items purchased before Jan 1 2005.
2) Record stock buy back programs (short term propping up of sotkc which may or may not be good for the long term outlook of the stocks), with correspondingly shrinking dividend yields (which SHOULD make long term holding of stocks less attractive unless one assumes the buybacks will continue perpetually like the dividends) and the insiders are selling into the strength in record numbers (I heard the most since 87). It’s almost as though shares are changing hands between the companies (thus shareholders) and the insiders. Why?
3) About a third of the yoy earnings growth last quarter can be attributed to insurance companies for the obvious reason. How much of that is sustainable?
As for those who believe S&P can achieve yet another round of 20+ PE I have this question:
In the year 2000 high beta ‘new economy’ stocks ran rampant, dominating major indices and driving the P/E ever so higher. Now the same indices are dominated by the ‘old economy’ stocks, with traditionally lower P/E. For there to be a further expansion in P/E the high beta stocks will have to rise again, to a much loftier valuation than where they are now. Looking at the P/E of the Q’s and valuations of its bellwhethers like GOOG, RIMM, AAPL and EBAY, is that achievable?
But how can we tell? Lots of conclusions and unsupported assertions are built in — highly subjective — but there was no persuasive proof.
Exactly what I was asking previously about using keyword searches as a sentiment tell.
After all that bruhaha before the election about illegal aliens being arrested and sent home and erecting walls at the border by both parties, mortgages are still being approved by Fannie Mae for illegal aliens with no money down, no documentation of income, and negative amortization. This has got to be a shot in the arm for the housing industry until Bernanke starts to lower rates, and the homebuilders move to areas that are less “bubbled out”. The old adage, “Figures don’t lie, but liars figure” should be changed to “Figures lie, and liars don’t have to lie anymore”.
A descent explanation for why P/E ratios expand and contract from Ed Easterling in “Unexpected Returns”(as I understand it) goes something as follows:
The dividend yield and P/E ratio of for relatively obvious reasons are pretty clearly inversely related as dividends are paid from earnings. The ratio of earnings to dividends in the S&P 500 has averaged about 50% for the last five decades.
Inflation makes the risk premium on stock dividend yields go up relative to the lower risk bonds. EPS and Dividend yield Thus eras of high inflation tend to cause a constriction in PE as investors are willing to pay less for the same amount of dividend yield.
Todays relatively high PEs are a reflection of what has been relatively low inflation. He goes on to note and explain that essentially the same thing happens in deflationary periods (which he states as 1% or less inflation).
I have run a study of trailing P/E’s in comparison to Treasury yields over the last 20 years.
By that metric, equities look as cheap as they have at any point during that period.
Moreover, there appears to be quite a strong relationship between the valuation of equities (expressed by trailing P/E’s) vis-a-vis bonds and future equity performance.
Using the relative level of earnings yields versus Treasury yields appears to provide a relatively effective filter that substantially improves the performance of a simpel buy and hold strategy.
As noted above, the indicator suggests that equities are a ‘strong buy’ at the moment, with relative stock/bond valuations at levels that have produced 27% annualized price returns in the S&P 500 since 1986.
Click on the name to see the study, or go to
http://macro-man.blogspot.com/2006/12/beta-release.html
Barry:
I find any type of argument stock market valuation based on PE multilples to be flawed from the get go. The bottom line is that the value of a stock is based on a claim of future cash flows discounted to the present. A PE ratio based on accrual accounting gives a very distorted view of what a stock is actually worth due to non-cash items in the income statement. The point is, why even use a PE ratio to measure the value of the market? Why is Wall Street not using Price-to-free cash flow (FCF) as the benchmark for comparing market valuations? Have all the CFA’s out there forgotten that you can not make payroll or any other expenses using accrual method earnings? In my opionion a PE ratio is a tool used to fool the uneducated masses into thinking stocks are undervalued, Graham and Dodd PLEASE.
Frank
Perhaps it is because that data is not widely available on an index-level historical basis, and thus makes it difficult to eprform apples to apples comparisons?
I am not making excuses for using a less rigorous metric, but simply offering a hypothesis.
Does anyone else see the wave of M&A activity as a sign that P/E’s/valuations, whatever you want to call it are cheap in the context of other investments and possible returns?
Why are all these companies being acquired, taken private, etc.? Cash is king and companies have tons of it. Should bode well as a cushion for the market in general.
Jdamon
Quite. When the (trailing) earnings yield of company x is higher than the return they get for slapping the money on deposit, it seems like quite an easy choie for many companies to make.
“Cash is king and companies have tons of it” is an oxymoron.
How so?
The spread between treasuries and corporate bonds has NOT increased since the Fed “tightening”.
Is anyone claiming it has?
You can lead a horse to water, but you can’t make um drink it.
Mac Man,
Can you demonstrate why the elements of the points you’ve made nevertheless couldn’t prevent a decline in P/Es from 24 to where they are now?…. from 22?… even from 19?…
Since they’ve contracted from the mid-20s, what makes you so sure they won’t contract to 12?… or 9?
Well Eclectic, as I am sure you can appreciate, if earnings go up more than price, the P/E ratio declines. Given the low base from which earnings started a few years ago, this is precisely what happened. Can it continue? Of course. If earnings growth continues to rise more than stock prices, the P/E ratio will continue to decline.
However, as investors, what we care about is whether stock prices rise. Which they have.
The P/E ratio is simply a tool that helps us determine whether they are likely to do so in the future. My study compared P/E ratios to another popular investment, Treasuries, and concluded that at current valuations, stock prices have historically performed strongly.
Can the valuation get more attractive? Sure. Is the study infallible? No. Are you guaranteed to make money buying equities here, there, or anywhere? Of course not.
But I tell you what. If P/E ratios were to drop to single digits with the entire US Treasury curve on a 4 handle, it would in all likelihood represent the most tremendous investment opportunity that many of us are ever likely to see.
Which means that it probably won’t happen.
“However, as investors, what we care about is whether stock prices rise. Which they have.”
Since when are investors only after the Stock Price? In Graham and Dodd-ville I’ve learned one thing, and its the same thing that Warren Buffett learned at my age. Investors buy companies, not ticker symbols.
“Which means that it probably won’t happen.”
Apparently, you haven’t been around long enough either. Do you know that we’ve seen one-digit ratios many times in history, and history does not start from 1980.
Furthermore, a bear market, however long it may last gives In Investors the opportunities to buy a great company at a great price for as long as its earnings remain cheap relative to share price.
The P/E ratio doesn’t tell the investor whether or not the stock is cheap but rather how much that company-advantage has been built into the stock.
It’s also come in handy when dollar-cost averaging, telling the investor that he may want to start placing more of a lot into cheaper shares.
Thus it’s no coincidence that Berkshire Hathaway bought Coke after the 1987 crash at a ratio of below 15 and kept buying until it reached a ratio of 23 – apparently Warren’s personal assessment of what cheap no longer stands for.
We are now, currently, in a bear market as we’ve seen P/E ratios come down and will continue to for some time.
So Macro Man, if you are a hardcore investor get ready for some rough years – albeit with great buying opportunities – over the next decade or so.
If you don’t have the iron stomache (or the time) then I suggest finding a commodities broker real soon.
Uh…..for those of us not in private equity, we buy stocks. They are shares in companies, but they are not companies in their entirety.
If you own 1000 shares of Coke and the stock price goes down more than the dividend , you have lost money, regardless of what the earnings have done. There is no arbitrage function other than private equity or the purchase of a company in its entirety to ensure that the economic value of corporate earnings accrue to shareholders.
Evidently, your copy Graham and Dodd failed to include any mention of discount factors. P/E ratios are meaningless without the applicaton of a discount factor with which to render a net present value to future earnings streams. The higher the discount factor, the less one should be willing to pay for future earnings today, and the lower the P/E one should demand. Conversely, the lower the discount factor, the higher the NPV of future earnings is, and the higher the P/E one could demand.
I am acutely aware that P/E ratios have been single digit in the past; more aware, evidently, than you are of what interest rates were during the same period. My data shows the SPX with a single digit trailing P/E from March 1977 to December 1982, for example. The average 10 year yield during that period was 10.75%. When Warren bought Coke in 4Q87, the 10 year yield was 9.1%. That yield is now 4.52%, which implies that future earnings are worth substantially more today than they were in the 70’s or 80’s.
If you read my post carefully, you will observe that I said that single digit P/E’s with the entire yield curve yielding 4-something percent would be a tremendous opportunity. If rates were 20% or even 10%, I would have a different view.
I would also take issue with your notion that the direction of P/E’s dictate the trend of the market. P/E’s have come down because earnings have gone up faster than stock prices. That does not signify a bear market. Similarly, P/E ratios went up in 2002, a period one could hardly call a ‘bull market.’
Finally, you should recognize that there is more than one way to skin a cat. You are evidently a bottoms-up fundamental analyst. Good luck to you.
There are those of us, however, who are primarily top-down macro traders who do more index trading than single stock investment. It is entirely possible that people of reasonable intelligence and goodwill can arrive at contrary opinions. This does not necessitate, as many people seem to think, that one of these people is stupid or naive or morally deficient.
So good luck with your investment bible but please, keep your broker’s number to yourself.
Thanks for your thoughts. I only argue for the pure sake of knowledge and clarity. I understand that you aren’t a mere speculator like the rest of them. I enjoy the Macroeconomic view very much as well as the primary-security-analysis of a single equity.
Thus I enjoy your comments and read them often.
The Fundamental Value Investor, even when looking at future earnings expectations, takes into consideration the margin for error and will therefor be reluctant to buy any security with prices over 15 times earnings (of course each to his own margin of safety).
You’re example of interest rates yields during periods of higher inflation, which we will probably see once again in the future, will explain why bond investors exist at all.
My macroeconomic stance is not one based on P/E ratios, that would be just like buying something because it went up. It is however a much more sound sentimental analysis, similar to that of Barry’s that we’ve completely lost touch of the inherit risks in markets and consequences of a lack thereof. In addition bear and bull markets are defined by the business cycle – which translate into the equity markets. Earnings have done phenomenally well over the past few years and many will agree that we will see less. As we do P/E ratios will rise (just like they did in late 2000) and that will force many to sell their obviously overvalued positions. The trend will most likely repeat itself many years to come.
Good luck trading to you and maybe there will be opportunities in commodities from a macro prospective.
Thanks for your thoughtful response. I would concur that future earnigns growth is unlikely to replicate the path of the last three years.
While it would obviously be useful to know exactly when and how any deterioration will occur, sadly we aren’t blessed with perfect foresight.
Fortunately, we don’t have to know six quarters or even six months in advance. As long as we figure out that things have gone pear-shaped the day before the next guy, we have time to get out.
FWIW, my1, I have updated the study through 1968.
cheers
http://financialsense.com/editorials/bronson/2006/1208.html
I am curious about P/E ratio forces. What are the various forces that can feed directional P/E movement? e.g. Price is equity value/share but this does not reflect (or does it) the amount of debt you have within your EV. Also, Earnings now include expensed options and may have different accounting elements as we had in the first quarter of the century.. what are the differences?
What I am getting at, is do you guys see any ways that the current PE ratios may be lower than they would be if they were normalized for the variables present in times past?
G