Where PE Ratios are Pointing

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A number of market gurus have been looking into PE ratios recently. And they have been reporting their intriguing findings at length. For good reason

Here’s a summary of the deluge of analysis: the next ten years don’t look rosy for stock markets, in much the same way as the decade to 2010 ended up being disappointing.

First of all, a quick explanation of Price-to-Earnings ratios (PEs).

Warren uffett-type value investors believe there is an inherent, or intrinsic, value to a stock based on its future earnings. When price is below that value, the stock is a buy. When prices rise above it, the stock is a sell.

The trick is in calculating the value of the stock. All sorts of ‘ifs’, ‘buts’ and ‘whens’ come into the equation, as well as margins of safety. It takes a lot of time to complete the analysis, as our own value analyst, Greg Canavan, can tell you. He applies this analysis to ASX stocks in his newsletter Sound Money. Sound Investments.

Part of the analysis – and perhaps its broadest summary – is the PE ratio. Put simply, the PE ratio is how much you are paying for future profits. The ratio is the stock’s price divided by its expected earnings. The price is what you can buy the stock for in the stock market. How you define expected earnings is the tricky part. We won’t go into it.

A high PE ratio indicates share prices are high relative to a company’s earnings. You pay a lot relative to what the company is expected to make. Low PE ratios indicate stocks are cheap relative to earnings.

At what point PE ratios become expensive/cheap depends on the individual’s opinion and history of the stock. How much are you willing to pay for the earnings of the company and how much have people tended to pay in the past are the key questions in determining what the PE ratio is telling you.

The whole analysis can be applied to an entire stock market index in many different ways. The point being much the same: is the stock market overvalued or undervalued based on the price paid for future earnings of the companies in the index?

One last item of theory: the efficient market hypothesis suggests all analysts are able to perfectly predict the earnings of a stock. This means that a stock’s price will always equal its value. Put simply, stocks are never over or undervalued. They are always just right.

So what has prompted the revered John Hussman, Mike Shedlock and John Mauldin to cover the state of PE ratios recently? (Sound Money. Sound Investment editor Greg Canavan also discussed it on Friday.)

While many of the world’s stock markets remain below 2007 highs, stock valuations relative to earnings are closing in on lofty heights that tend to spell disaster. Put differently, PE ratios are reaching dangerous highs compared to their norms.

There are several ways to think about this. If you believe in efficient markets – that prices equal intrinsic value – then earnings would have to grow dramatically over coming years to justify current prices. A more likely explanation, for those who don’t believe in perfectly efficient markets, is investors are too optimistic on the outlook for earnings. And this is causing them to drive prices up to levels above intrinsic value. Well above.

An additional and pivotal cause for concern is that companies are too profitable at the moment. It sounds ridiculous, but as a Daily Reckoning reader should know, high profits don’t last ‘unless capitalism is broke’ -as John Mauldin puts it. Competition pops up, employing people along the way. This reduces corporate profits exactly when the economy begins growing again. Kind of counter intuitive, which explains the unjustified earnings predictions of the mainstream .They expect the economy to grow and companies to increase profits.

When earnings are revised downward, prices will have to follow, or PE ratios will become even more unjustifiable.

Just eyeballing the chart of a popular type of index PE ratio, it isn’t difficult to see US stocks falling 50% before becoming reasonably priced. And that’s at current earnings projections. If capitalism kicks in, reducing profits, the justifiable prices based on past PE ratios will be even lower.

The problem with this prediction is, as Keynes said, ‘markets can remain irrational longer than you can remain solvent’. In other words, high PE ratios could persist as investors wait for earnings to improve – something that may never eventuate. Of course, this is rather ironic, as those postponing the recovery with their anti-capitalist policies are doing so in Keynes’s name. The government is keeping the market irrational.

Anyway, the PE analysis done by the three gurus mentioned is warning of a downtrend. These tend to last about two decades according to John Mauldin’s analysis. Our two-decade slump in stock markets began in 2000, so we are in the second half.

The implication is that the stock market won’t be pretty for buy-and-hold-type investors over the next 10 years. At least for those who believe in diversification over careful stock picking.

Oh, we forgot to mention the third explanation of dangerously high PE ratios. It needn’t be because investors expect earnings to rise dramatically. Perhaps investors are just becoming willing to pay more for earnings. Or they simply prefer equities as an asset class. This would drive up prices regardless of earnings. In other words, it’s an asset allocation matter.

There are several reasons why equities might be more popular than before. The ideas that stocks rise with inflation and the end of massive bull markets in housing and bonds are two of the big ones. You have to put money somewhere. Especially when the government forces you to in the name of retirement.

But this doesn’t undermine the value investor’s premise. As housing investors around the world discovered – and Australian housing investors are going to discover – the idea that people are willing to pay more for something than before is a passing cause for high prices. At some point, preferences change back. Which is difficult to predict, as people’s whims do not conform to the analysis of PE ratios in the short term.

So, for now, the stock market is an apparition of what it is supposed to be. After seeing bubble after bubble roll in and pop under the watch of central bankers, law makers and other monopolists, you don’t have to be a genius to figure out the stock market isn’t efficient. Prices don’t stick to intrinsic values, they fluctuate all over the place. And stock markets aren’t very helpful in predicting future earnings of the economy.

But if stock markets fail as a forecasting mechanism, making them useless as a leading indicator of economic prosperity, why are higher prices considered to be good news? After all, as implied above, an improvement in the economy needn’t equate to higher profits, which increase stock prices.

What makes higher prices good in the stock market, when they are bad in the supermarket?

Hint: The supermarket likes high prices.

Yes, it’s the finance industry that has you interpreting upward moves of the index as good – signified by a pleasant green colour – and falls in the market – signified by an angry red – as bad.

Of course, the value investor knows better. A fall in prices means prices are either reverting to their value, or becoming an even more attractive buying opportunity.

And even in the most overvalued markets, there are buying opportunities.

Nick Hubble
For Daily Reckoning Australia

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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Comments

  1. Good article Nick

    Reply
  2. Have just been tidying up the novel detritus I’ve dropped beside my bed after reading Biker – Follet’s “Pillars of the Earth” was in the heap. If you enjoyed that then try Tolstoy’s “War and Peace” for sure I reckon. Plus I also find Frank Hardy’s “Power Without Glory” good for regular rereads. And Bryce Courtney’s “The Potatoe Factory” if one doesn’t mind stuff that’s a bit short on for smiley faces. ;)

    Reply
  3. Just put up a bit of stuff telling us house prices generally are going to drop 50% and how that will let YOU convert your $700K Woodvale WA property into a $2m Sorrento WA property and we’ll all be trucking along right ‘honest’ here as always Fool … :D

    Reply
  4. Surprised to see N Fool back, Ned. His logic and mathematics have been so suspect that he has reduced his long multiple blocks of print to a mere trickle. Very few CAPS these days, too. Either he’s hoarse from shouting, or he has morphed to rest his voice…

    And over at MMA, we’ve cured our mate of his persistent ‘erm’!
    It’s now ‘er’… !~ ;)

    http://www.moneymorning.com.au/20110325/why-australia-is-set-to-follow-us-path-of-house-price-doom.html

    Reply
  5. Jeez, mate… Your comment certainly knocked his Star Ratings and Thumbs for six!!~

    I’ll look out for ‘The Potatoe Factory’, Ned. Bill Bryson’s latest, ‘A Short History of Private Life’, is worth a read, particularly as it explores the housing theme historically… .

    Reply

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