More on P/E ratios and whether this market is cheap

Summary: The P/E ratio is a statistic that, while all-encompassing, can be misleading in determining under- and overvaluation. Nonetheless  regarding valuation it can be a useful guide in context.

I have written a lot about multiple expansion in the past year because I think this is a big issue. The United States is trading at a premium to other developed markets in terms of price to earnings and this multiple has been increasing even in the face of a recent increase in interest rates, which should cause multiples to contract. The real question here is one for fundamental analysis and valuation i.e. is this market as a whole valued fairly on a fundamental basis. And if not, what does that mean.

On this score, I like a recent analysis by Doug Short regarding P/E ratios. Here’s the crux of the analysis (the full version is here):

A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.


 The average P/E ratio since the 1870’s has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out.

As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. “Why the lag?” you may wonder. “How can the P/E be at a record high after the price has fallen so far?” The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.

Because of these problems, what most analysts do is time-adjust or earnings adjust the multiple in a number of ways. One standard way to adjust is to take an average earnings over a longer timeframe to smooth out aberrations. The Cyclically Adjusted Price Earnings Ratio (CAPE) is the standard way of doing this. Another adjustment that makes sense is to use a ‘real’ earnings number under standard accounting principles instead of the reported or forward earnings number because these latter two numbers are massaged and manipulated by the companies in order to show a flattering current earnings profile. The goal is to get the P/E ratio to have more significance as a true estimate of over- or undervaluaton for individual companies or the market as a whole. And I think that CAPE does a good job of this. Here is Doug Short again:

As the chart below illustrates, the P/E10 closely tracks the real (inflation-adjusted) price of the S&P Composite. In fact, the detrended correlation between the two since 1881, the year when the first decade of average earnings is available, is 0.9976. (Note: A perfect positive correlation would be 1 and the absence of correlation would be 0).

S&P500 and the PE10

The historic P/E10 average is 16.5. After dropping to 13.3 in March 2009, the ratio rebounded to an interim high of 23.5 in February of 2011, and then hovered in the 20-to-21 range. The latest ratio is at same level as 2011 interim high. The ratio in the chart above is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices for the index). Thus the fluctuations during the month aren’t especially relevant (e.g., the difference between the monthly average and monthly close P/E10).

Translation: the market is far above its average when measured on a backward-looking cyclically-adjusted basis that has been known to be highly correlated to actual earnings.

What this says to me is that this market is expensive. And the question therefore has to be why is it expensive. I have posited that it is not just lower discount rates since the market has resisted the increase in interest rates. Rather, multiples expand with the business cycle because prognosticators use the present a s a baseline to extrapolate into the future. And therefore, when the business cycle is up, earnings and multiples tend to both go up. This is what makes a secular bull, the expansion of earnings and multiples across multiple business cycles.

Right now, there is a lot of questioning as to whether this cyclical bull market is overbought i.e. riding a wave of multiple expansion which will come unstuck in the next cyclical downturn. I believe the answer is yes, that we are in the fat tail of the P/E multiple bell curve and Doug Short’s analysis says this is so as today’s market is in the 89th percentile in a historical context. Only 11 percent of cases are more ‘overbought’. What you need to see here for a true problem is a 2 standard deviation move i.e. something that is 2 standard deviations from the norm, putting it into the 97th percentile. This is the area where the tails are fattest and where bursting bubbles cause massive downside risk. We are not there. But the fact that we are in the 89th percentile suggests that we are not in a new cyclical bull market. There are only 11% of historical observations higher on a P/E level, profit margins are historically high and mean-reverting, and interest rates are historically low. All of these headwinds say that we are at the top of a cyclical bull cycle that will mean revert into a multiple contracting period when this business cycle turns down.

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