Composition of Portfolio Profits and the PE Ratio
One of my New Year’s resolutions is to actually say a few nice things about op-eds from NRO Financial – when warranted. And lo and behold John Tamny tries to make this easy for me. He starts off with:
A recent article in USA Today lamented the lack of investor returns in 2005 outside of energy stocks and Google shares. To wit, while S&P 500 earnings are up nearly 50 percent since 2000, the index remains 20 percent off its high.
In other words, the price to earnings ratio has fallen as this link documents. Tamny asks why and offers this explanation:
Although earnings presumably belie the S&P’s price, the index’s performance becomes more explainable once the nature of those earnings comes into full view. In the last quarter alone, S&P earnings rose 16.1 percent. But that same number falls to 10.4 percent when you strip out the earnings of oil companies. While the latter result might at first glance seem unimportant, it becomes very important when you take into account the history of government reaction to commodity profits worldwide.
Until the last sentence, I found myself nodding my head in partial agreement. After all, the price to earnings ratio varies across sectors just as it varies across companies. Aswath Damodaron provides sector wide price to earnings ratios (as of January 2005 in addition to providing data for the years 1999 to 2003), which vary substantially across sectors as well as across time. His tables across provide data on the fundamentals of market valuations including expected earnings growth.
One of the explanations for the very high price to earnings ratios of the early 2000’s was simply that the market expected rapid earnings growth in the future. As Tamny notes, S&P earnings are currently about 1.5 times where they were back then. If the market is no longer expecting rapid earnings growth, traditional financial economics would suggest a lower price to earnings ratio. Tamny also notes that oil company stocks have led this growth of late. Unless the market expects oil company stocks to continue to increase rapidly, then why would anyone be surprised that the price to earnings ratio for an oil company stock would be lower than the overall price to earnings ratio?