So much for the double-dip recession and a new bear market. With upside surprises Wednesday in the Institute for Supply Management's manufacturing survey and Friday morning's August jobs report, it's safe to say the correction in stocks is over.
I knew this was going to be a good week in the markets when I looked in my inbox Monday morning. There was one particular email from a regular reader of this column, who was politely but firmly skeptical of my rather bullish take last Friday, which was based on the fact that consensus forward corporate earnings continue to move higher.
This reader pointed me to an article in Monday’s Wall Street Journal, which stated that growth estimates are moving lower. He suggested those estimates undermined my bullishness. In fact, that is no contradiction at all. Growth estimates and earnings estimates are very different. Growth is the difference between past earnings and future earnings. Future earnings are expected to rise, as I said. However, past earnings are rising too. So the difference (growth) is narrowing. I explained this phenomenonin in a column a month ago, when I talked about how the huge operating leverage at companies, which was temporarily impaired by the recession, would lead to big earnings growth even in a slow economy.
But none of that wonkish stuff was the real point of the Journal article, and it's not what's gotten me so inspired. The article was called "The Decline of the P/E Ratio," a double entendre based on the fact that P/E ratios have fallen to very low levels in this year's stock market correction and the author's contention that P/E ratios have declined in importance as an indicator of value.
Does this all sound somewhat familiar? Somewhat laughably familiar? How many articles like this came out in 1999 and 2000 at the peak of the dot-com bubble, when P/E ratios had risen to stratospheric heights that, by all previous experience, indicated that stocks were massively overpriced? The articles then said the same thing as this one did on Monday -- that it's a new world in which P/E ratios don’t matter any more.
Back then, many of the hottest companies didn't have any earnings at all, so their P/E ratios were "infinity." But no matter. Get your position in that pet-food delivery web site, no matter what! As we all know, the old-fashioned wisdom about P/E ratios turned out to be absolutely correct. They were too high. The NASDAQ crashed from 5,000 to 1,000 over two years. The companies that survived had more realistic P/E ratios at the end of that horrific experience.
So how perfect. How symmetrical. In 1999, we had to ignore P/E ratios because they were too high. Now in 2010 we have to ignore them again, but because they are too low. That was the upshot of the Journal article.
This is the way markets work. Tops happen when people become irrationally exuberant -- they ignore the warning signs telling them there is trouble ahead. Bottoms happen when people become irrationally despondent -- again, they ignore the signs telling them the trouble is over.
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