Price to Earnings Ratios Show US Headed Off a Cliff: MBA Monday

by Darwin on March 14, 2011

Price to Earnings Ratios do predict future market returns to some degree.  The problem is sometimes secular trends and P/E expansion/contraction end up playing a stronger role than comparison to historical P/Es alone.  So, let’s take a look at these various concepts and see where we’re at now in this week’s MBA Monday at Darwin’s (click for all topics):

Price to Earnings Ratio Defined

The Price to Earnings ratio (P/E) is a very common measure for publicly traded equities whereby you divide the share price by the earnings (new profit) during a given period.  In some cases, analysts and investors are looking at “trailing P/Es” which might be the prior year or quarter, or they look at the “forward P/E” which would project the current price over anticipated earnings.  That method is obviously prone to error given the divergence of future earnings forecasts for any given stock.  When looking at the US market as a whole, it’s commonplace to look at the P/E ratio of the S&P500 (SPY) as an indicator of the market at large.  Typically, the US market trades between a range of 10 and the low 20s.  Remember the dot-com bubble crash?  P/E ratios were more than double that, peaking at about 45.  And we all know how that ended.

Price to Earnings Ratio Relevance

A lot of times, you’ll hear Cramer or some analyst touting the “value” of a particular stock because it has a low P/E ratio or that it’s expensive with a very high P/E.  If you’re a proponent of efficient market theory, none of that matters for individual equities, as the market has already priced that in.  What makes a simple P/E somewhat irrelevant for individual stocks is that they’re all growing at different rates.  So, I’d love to have paid a 25 P/E for Apple or Google earlier this decade, but paying a 20 P/E for a utility stock?  Ripoff.  That’s where the PEG ratio comes in which incorporates growth rate as well (subject of another post).  However, for the market at large, earnings and growth rates are a bit more predictable and errors are more easily canceled across hundreds of stocks.

 

P/E Expansion and Contraction a More Important Indicator?

I came across a really incredible tool provided by Crestmont Research.  Essentially, by looking at decades of history to see how stocks have performed into the future based on various P/Es in time, there’s a very clear pattern that develops.  The lower the P/E, the better the future returns on stocks and vice-versa.  Now, this concept isn’t rocket science at face value.  But by analyzing the actual data and comparing where we are now versus how this has panned out virtually every other time in history, it looks highly likely that from here, we will have either a negative or just marginal returns in the stock market for years to come.  See, while it may appear that stock market returns are random in any given year, there is undoubtedly very consistent performance across long periods of time (10 years or more) that is very predictable based on starting P/E ratios.  Here’s a quick snapshot of the data, but check out for yourself; it’s intuitive after looking at it for a while – especially the legend description:

Based on decades of history and numerous consistently executed pattens, we are heading off a cliff in terms of equities returns.  The chart closes with 2010 at a 21 P/E and it’s showing as an incredibly expensive 24 P/E today (Multpl.com).  When you look out at the 10 year, and even the 20 year annualized returns following a period of 20 P/Es and higher, it’s quite ugly.  Usually, a good time to invest was when P/Es were in the teens or lower.  The only thing that would change the outcome here would be a sudden P/E expansion, which doesn’t seem logical given the recent shock to the retail investor and an aging demographic that pushes seniors into less risky assets, not high risk assets.  Add to that the value destruction in home equity and a lousy jobs picture and it’s tough to envision a scenario whereby P/Es actually undergo expansion rather than contraction.  Unfortunately, the alternatives aren’t great.  It’s tough to find safe high yield investments thanks to the Fed, gold and silverETFs be in a bubble, and it’s tough to find non-correlated assets since the world is getting smaller (which we learned all too well during the 2008-2009 crash).

 

Do P/Es Matter in the End?  What are Your Thoughts?

 

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