P/E ratios and an overvalued market

Bruce McWilliams - Tue 09 Mar, 2004

...In the investment world, so-called gurus and investment professionals decry high P/E ratios and say, The market is overvalued, chicken little. Sit on your hands and wait for the sky to fall in....

P/E ratios and an overvalued market

Watching the Oscars a fortnight back, it struck me that members of the Academy simply vote on which film they like best. There is no requirement that the film be technically excellent. Or that it made the most money. Or that it even was the funniest, most serious, loudest, longest...nothing.

So when Sean Penn won Best Actor for Mystic River - in which I felt he overacted, but no one at the Academy asked my opinion - you didn’t see Johnny Depp say: “Hang on, my film, Pirates of the Caribbean, grossed a lot more money.” He applauded when Penn’s name was announced.

Yet in the investment world, so-called guru’s and investment professionals decry high P/E ratios and say, “The market is overvalued, chicken little. Sit on your hands and wait for the sky to fall in.”

You may know a guru or two who works on this principle. But if only they were more like the Academy, they wouldn’t miss out on so many great short-term gains from trading shares. Because a high (or low) P/E ratio for the market as a whole tells you nothing.

P/E ratios and an overvalued market: An easily understood tool

Yes, of course an individual stock’s P/E can be a valuable tool. Dividing a stock’s price by the earnings it made over the last 12 months offers you a short-cut. It values the company as the sum of its expected future earnings - one simple, easily understood statistic.
 
But here is where everything goes haywire...because what is true for the individual is not true for the population. Some companies have losses, some use different accounting policies, industries go in and out of fashion...for all these reasons, and more, you cannot draw inferences about the broader population of the stock market, based on this simple measure.

If you go back two hundred years and study American stock market values, the average market-wide P/E ratio has been 14.8. But today, the average P/E ratio on Wall Street is higher, around 22. Hmmm...because the P/E ratio is above its long-term average, investors like you would clearly be better off waiting until the ratio drops below the average - say to 10 or 12 - before you start investing again.

Would you really? For one thing, you’re going to have one helluva long wait. Stock prices would literally have to drop in half. Or earnings would have to double. It’s true that US corporations have seen a big improvement in earnings over the last year. They will get even better owing to the low dollar. But they haven’t doubled, and won’t for a good while yet.

P/E ratios and an overvalued market: Above average

No matter. The recent P/E ratio of the market has already been above its average for a long time. Professor Jeremy Siegel of Wharton University, author of ‘Stocks for the Long Run’, is credited with calculating that 200-year figure of 14.8. He asserts that market P/E’s of 10 are not going to happen in the foreseeable future.

I interviewed Professor Siegel for the Financial Times last year. He told me that today’s record low interest and inflation rates are another reason why P/E ratios will stay high in the US - because earning yield figures will be lower than expected.

The earnings yield is the total return you get from an investment - dividends plus non-distributed earnings - as a percentage of the price you pay. It is quite literally the reciprocal of the P/E ratio. Today’s price/earnings of 22 implies an earnings yield of 4.5%. But the historical P/E of 14 means the US stock market has generated a 6.8% return for investors on average (the reciprocal of 14). Obviously, there are highs and lows around that figure, but that is the average.

Siegel cites the period after WWII, when the Dow Jones index still hadn’t regained its 1929 high, and investors continued to pass up high yielding stocks in favour of super low-yielding bonds. The stock market did recover...regaining its 1929 peak in 1954. But those investors waiting for the rating to drop, missed out.

“Why do we believe that P/E predicts the future?” asks professional US money manager Kenneth L. Fisher. He reckons it equates to some human need for fairness and simplicity. A high P/E implies lower stock market returns...or even losses...while a low P/E suggests strong returns.

But writing in Forbes Magazine about ‘The P/E Myth’ last November, Fisher put it succinctly when he said that: “There is no linkage of market P/Es to subsequent returns - no matter how you measure the ratio and no matter how long you measure returns.”

P/E ratios and an overvalued market: No statistical linkage

His analysis, which was also published in the Journal of Portfolio Management, showed no statistical linkage between market P/E’s and subsequent returns. This is true no matter how you measure the ratio. For every instance in which high P/E markets did badly or well - however determined - there is an almost identical number and magnitude of times they did the reverse. Fisher’s study looked over 125 years of data.

Bring this closer to home, back to you in Britain, one year ago today. How many investors do you know who jumped into the market as March 2003 wore on? Someone using market P/E’s as their only guide would have avoided the market altogether...and missed out on a near 50% gain in the last half of 2003.

Ken Fisher constructed another test. Make any trading rule you like based on market P/E ratios, he says. Sell at 20, buy at 8, sell at 18, buy at 10 - whatever. No rule will work to deliver gains or avoid losses. Vastly more often than not, in fact, you will miss a rally...but you will catch the market’s correction.

Fisher then tested data from the London Stock Exchange, too. Same result - “market P/E’s don’t work,” he concludes.

P/E ratios and an overvalued market: 'What's an investor to do?'

So what’s an investor to do? Ignore market P/E ratios and focus on individual companies? The answer must be yes. Furthermore, as with the Oscars, we should focus on what makes a share popular.

Start by looking for companies whose share price is rising. Then yes, look at individual company P/E ratios, and use them as a measure of value. But be sure to compare them with other P/E ratios in the same industry - not across the wider market as a whole. This is how I select my own investments, as well as those I analyse for readers of my US stock selecting service.

My first screen comes from the top investment writers in the US. Which stocks are proven experts - with the best track records - currently recommending?

Next, I determine which of those US stocks have significantly positive technical indicators. Like the Oscars Academy, I look for shares which are rising - suggesting popularity - not some vain statistical symmetry. The companies I choose are either low price growth stocks, or higher price deep value stocks.

Finally, I assess whether the stocks are right for my British readers to buy. Are they liquid enough so you can get into and out of them when I issue a sell signal? I want to verify that the spread between the buying and selling price is not obscene. And today, I ask whether you can spread bet them, to leverage your gains further.

These are the three steps I’ve developed over 25 years analysing the US markets, and advising private investors how to make money from them. First, find out what other proven experts are buying. Ensure they are high growth, low cost stocks...or offer deep value from among America’s greatest investments.

Next, check that the technical conditions imply the stock is going to be a short-term winner. Finally, make sure you can actually get a hold of it.

And don’t worry yourself about what the market P/E might or might not be. It doesn’t matter.


Regards,

Bruce McWilliams
for the Daily Reckoning

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