A Focus On Valuations Is the Time-Tested Path to Lousy Returns
“Too pricey, still!” So say a plethora of pessimistic pundits--about stocks. With price/earnings ratios and other valuation metrics quickly regaining on—even surpassing—pre-bear market highs, experts decry why any darned fool would ever buy stocks. Especially so since lingering lockdowns lead second and third quarter earnings straight to Craterville. Why, why, why? Here’s why: Valuations are time proven terrible timing and market direction tools—less than useless, in particular, early in bull markets. Paying them heed bites a recipe routinely missing bull market gains.
When people call stocks overvalued, they compare stock prices to measures of companies’ underlying business values. The most common is the price/earnings ratio (P/E), which divides a stock’s price by its per-share earnings. Some P/Es use past earnings. Others utilize projected future earnings. Then there’s the much vaunted market-wide cyclically adjusted P/E, or CAPE—using the past decade’s inflation-adjusted average earnings. Some do it varied other ways.
Other valuation metrics abound. For example, “price to book” depicts—in theory, what is left when a firm liquidates and repays all liabilities. In the 1980s, I pioneered the price/sales ratio (PSR)—dividing stock prices by corporate revenues per share. The PSR underpinned my 1984 book, Super Stocks, which argued folks too quickly dismiss unprofitable companies. Comparing prices to sales back then unlocked opportunities in overlooked deep value firms working through short-term profit problems. Ignore all of these metrics for market direction help. They simply don’t.
Forward P/Es are actually significantly above pre-crash levels—doubly shaky, pessimists proclaim-- because the estimated “E” will decline but unpredictably much in this environment. This bear market price plunge didn’t implode because valuations were too high, or because the economy was shaky. It did due to widespread government-mandated economic lockdowns to stem COVID-19’s spread. You know that. And in all-time record speed off all-time highs--16 trading days to full throated bear market territory.
I’ve studied P/Es for decades. They aren’t predictive in any timeframe any investor really cares about. Consider: In the 146 years through 2019, trailing P/Es told you basically nothing about where stocks would be one, two, three, or five years later. How do we know? A complex but routine statistic called “R-squared.” It tests whether one recurring phenomenon possibly causes another. R-squareds near zero document next to no causality from P/Es…or from basically any other common valuation metric you may choose. So, ignore them.
Why is this so? Again, consider P/Es because they’re the most widely used valuation metric. First, they employ prices, which by themselves don’t predict future prices. Second, and crucially, as I already said… everyone uses them. Stocks price in all widely known information. And P/Es may be the most commonly discussed investing tool in the whole wide world—hence arguably the most pre-priced phenomena, ever. Try to find any investor anywhere of any material experience who doesn’t understand P/Es and factor them into his or her thinking. You can’t. And thirdly, most valuation metrics are either backward looking or current. But stocks are always, as I often preach, forward looking--pre-pricing a reality some three to 30 months into the future and often fairly far into that future.
Hence, valuation metrics are beyond useless, particularly right now. As cited here in my May 26th column, toward the end of bear markets and early in bull markets, the Pessimism of Disbelief always creates glaring distractions keeping people from envisioning correctly any new bull market—particularly, in this case, with valuations. For example, recessions’ deteriorated earnings commonly inflate trailing P/Es even after prices plunged. Why? Take 2009. The S&P 500’s trailing 12-month P/E soared to levels unseen since the dot-com crash, thanks to putrid late-2008/early-2009 profits dragging down the P/E’s denominator more than prices fell. Yet that formed the beginning of history’s longest bull market—a generational buying opportunity.
Unless current business lockdowns extend late into 2021 or later—earnings and sales from recent months or near future months make for wildly inaccurate gauges of what to expect from stocks--because the market now pre-prices a much further future. It always does early in every bull market. Always! P/Es using future earnings projections are equally useless. Wild guesstimates at best. The market does this kind of estimating (pre-pricing) very much better naturally than we all do, including the very best of us. Just let it do it for you without fretting its precision.
The lifting of lockdowns are political decisions, of course, and of an unprecedented nature and, hence, treacherous for you, me or your designated experts to predict well. Hence, earnings 2020 and 2021 estimates—which underpin forward P/Es—are meaningless for stock prices.
As this economy reopens, earnings and sales will rise at some point, moderating increases in P/Es and other metrics. But stocks move so very far in time before that--so that by the time those P/Es fall, making stocks look more OK to the “too pricey” pessimists, prices will—painfully and ironically—be far higher. Don’t let that valuation trap hijack your future profits.