Yesterday, Peter Boockvar referenced two WSJ articles on P/E: The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?
I believe these articles are asking the wrong question. Rather than wondering if the value of P/E ratio is fading, the better question is, “What does a falling P/E ratio mean?” The chart below will help answer that question.
We can define Bull and Bear markets over the past 100 years in terms of P/E expansion and contraction. I always show the chart below when I give speeches (from Crestmont Research, my annotations in blue) to emphasize the impact of crowd psychology on valautions.
Consider the message of this chart. It strongly suggests (at least to me) the following:
Bull markets are periods of P/E expansion. During Bulls, investors are willing to pay increasingly more for each dollar of earnings;
Bear markets are periods of P/E contraction. Investors demand more earnings for each dollar of share price they are willing to pay.
Hence, a falling P/E ratio is not indicia of its lack of utility. Nor is it proof of “Fustyness.” Rather, it suggests that crowd is still feeling burned by the recent collapse in prices and increase in volatility.
Thus, this is not about the market’s economic concerns, or sustainability of earnings. It is about psyche.
The 2008-09 crash follows (in order) the 2000 dot com implosion, the commodity boom and bust, and the Real Estate debacle. Is it any wonder investors are nervous? Their skittishness requires additional incentives to get them to purchase risk assets like stocks. Hence, the decreasing cost of owning equities as a natural result of the psychic pain of losses, still fresh in investor memories.
History teaches us that valuations typically become extremely attractive at the end of Bear markets. The P/E ratio — as well as the dividend yield, enterprise-value-to-free-cash-flow ratio,
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click for ginormous chart Source: Crestmont Research
Once again, our esteemed host is correct.
Also the house price can be thought of as a P/Rent ratio. And the government bond market? Well that’s getting you 40 times in your ten year/ intermediate bond fund. Let me know how you feel about THAT dusty old P/E ratio when the Fed, inevitably, starts raising rates.
Lets see. One variable is given by Dr. Leland Pritchard’s (Ph.D Economics, Chicago 1933), Dow P/E Theory which states that during increasing rates of (1) inflation there will be lower highs & lower lows & vice versa.
But in the current low inflation environment there is another more important factor – the expected growth rate of (2) real-output. Slower real gDp growth (stocks follow gDp), means, lower rates of growth in earnings (however defined), annual, trailing, discounted, etc. (or a “company’s total revenue less its operating expenses, interest paid, depreciation, and taxes”).
Who’s going to reach out for stocks, when many market participants are anticipating something analogous to Japan’s “lost decade” for the U.S.?
P/E expansion/contraction could be a function of demographic factors, specifically the MY ratio which is the ratio of middle to young (middle being the asset accumulators):
http://cowles.econ.yale.edu/P/cd/d13b/d1380.pdf
In my view, this explanation makes sense both theoretically, and it is a great fit empirically and explains why P/E ratios were low in the 1940s and early 50s despite low interest rates. It also explains the magnitude of the 1982-2000 bull especially the final parabolic blow-off from 96-00 as baby boomers entered their peak asset accumulation years.
This same theory suggests a bottom in P/E ratios in 2017-2018
http://humblestudentofthemarkets.blogspot.com/2010/09/waiting-for-2017-or-2018.html
I’ve been a believer in the 17-18 year secular cycles since first seeing Crestmont’s research many years ago, but for a long time I questioned the “WHY”. Was it divinely ordained? This demographic theory of driving the expansion/contraction of P/E ratios over 18 years (roughly 1 generation) seems to tie it up nicely.
It would be interesting to deflate the chart based on the value of the USD (historical values can be seen on wikipedia) to see market performance on a real basis and compare it to alternative asset classes…
Isn’t the real, though hidden, message of the two WSJ articles that the falling P/E ratio does not lead to the bullish story many people want to report, therefore they condemn the P/E ratio as fusty, old-fashioned, and out of date?
History teaches us that valuations typically become extremely attractive at the end of Bear markets. The P/E ratio "” as well as the dividend yield, enterprise-value-to-free-cash-flow ratio
Does history teach that this can be observed/realized in real time at the moment it occurs? I think history teaches that the answer is no. Among the thousands of people predicting the economy and stock markets there will always be a few who are right and afterward will claim perfect foresight. This is nothing more than survivorship bias and 20/20 hindsight.
In real time, P/E’s will look high at the bottom because analysts will have become pessimistic and project forward earnings too low (just as they project forward earnings too high at the top)
In real time, a high dividend yield will look like a prelude to a cut in the dividend – will you know that the bottom is nigh and dividend cuts are about to stop? Probably not.
So good luck with that strategy.
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