Stock Market PE
I have been asked to repeat some of my past post on the stock market. In particular they wanted to see this long term chart of the S&P 500 price/earnings ratio. Until the 1990s bull market a PE of over 20 on trailing earnings was always a signal of an impending bear market as a PE of over 20 was never sustained. There is a long pattern of the market PE swinging from over 20 to under 10. Moreover, even though many Wall Street strategist talk about the long term average PE of about 15, there is no central tendency for the market to converge on the average of 15 and it really does not stay around 15 any longer than around any other value. Prior to 1926 the data is from Robert J. Shiller’s Irrational Exuberance . From 1926 to 1989 it is from S&P and after 1989 I calculate it from S&P’s estimated operating earnings data.
I use operating earnings because it is what most professional investors use and I believe that the estimate of on going operations is the most relevant measure to value future earnings. Of course, right now it does not make much difference as operating EPS and reported EPS are about the same. Last year’s big difference between the two measures stems largely from the massive write-offs by financial firms . Moreover, much of the recent big snap back in earnings is the write-offs rolling out of the four quarter trailing earnings data.
But as these write-offs rolled out of the data is generated a big drop in the market PE based on trailing earnings to about 19. In my valuation model that makes the market fairly valued to cheap.
In a highly cyclical environment as we are now experiencing many people like to use an estimate of “normalized earnings” to eliminate cyclical earnings distortions. So if you use the 7% trend growth in the above chart of operating vs reported earnings to estimate the market PE you get very similar results. Shiller, and some commentators at this blog use the 10 year trailing earnings. When you are dealing with an individual company where the long term earnings growth trend can change, that rule is a very good practice and builds in a measure of safety. But the long term earnings growth for the entire market is unlikely to change rapidly, so I feel comfortable with this approach.
If the economy is in a Japaneses deflation trap of course the trend earnings would be lower.
So maybe we should look at the prospects for earnings. The recent productivity report received much attention. But I did not see anyone point out that the spread between nonfarm corporate prices and unit labor cost was 5.25%, the widest spread on record.
This spread is the single most important variable driving corporate profit margins and implies that you should expect major positive earnings surprises.
In addition, corporate profits are very much a function of deviations from trend in real GDP growth. So with margins extremely wide and reasonable prospects for above trend growth, profits should continue to rebound strongly.
With the big margins improvement profits in the national accounts have already rebounded to above trend.
The other thing investors worry about that could be a major threat to the market is inflation. I’m in the school that believes sufficient excess capacity in the economy, whether measured by the output gap, the unemployment rate or capacity utilization, to keep inflation under control for the time being.
However, there may not be as much excess capacity as many believe. Much of the unemployment is structural . Moreover, the Fed estimates that industrial capacity is actually contracting and the growth of potential real GDP is at record lows.
For this year, I do not expect this to impact many prices outside of basic commodities, but in the out-years it could become a significant problem.
Contrary to many claims, the reason capacity creates a potential problem is weak business fixed investment. Despite low marginal tax rates and record profits real
business fixed investment was extremely weak over the last cycle. I will not go into a whole litany of reasons for weak investments, but I will just point out that in the 1960s, 1980s, 1990s, and the 2000s that capital spending was inversely proportional to marginal tax rates.
So, I’ve given everyone a wide range of topics to discuss and debate. Have fun.
***Contrary to many claims, the reason capacity creates a potential problem is weak business fixed investment. Despite low marginal tax rates and record profits real business fixed investment was extremely weak over the last cycle.***
Perhaps an atrifact of an economy shifting from manufacture/natural resource extraction/agriculture to finance, insurance, etc? Is fixed investment a relevant concept for an increasingly large segment of our economy?
I would have included Information Technology as non-capital intensive, but in reality huge sums (they seem huge to me) are spent on computing/data communications hardware and its lifespan is pretty short.
Nice article — thanks.
In the 200s info tech accounted for 35% of the business fixed investment data in the chart.
But one of the problems with tech spending is that it has a shorter lifespan than traditional investment goods so more of the gross numbers reported is used to replace obsolete tech equipment. We have to run faster to just stay even.
Here is an interview that helps put P/E into a better perspective:
Bernard: How’s the book doing?
Fisher: The book’s doing very well. It’s been bouncing around in the last few weeks between number 80 and number 19 out of all books on Amazon. And it’s been running between four and 15 in the business category.
Bernard: In it, you talk about how the P/E ratio has no value how it’s used.
Fisher: It’s something that I started pushing a long time ago that’s never been publicly accepted. In the first chapter I show you that P/Es tell you nothing about risk or return. I take you through the history and show you that all P/E levels have historically shown the same results. The same ups, the same downs.
Bernard: What about earning yields?
Fisher: Right. I teach people to take the P/E and flip it into an E/P. Think of a company that has a P/E of 15. This means an earnings yield of 6%. (That’s the company’s after tax annualized cost of raising expansion capital by selling stock.) Its other option is to go out and borrow ten year money at about 6%. That’s a pre-tax number. After tax it’s about 4%. So the company borrows money at 4%, and it buys back its own stock with a 6% earnings yield. The earning per share goes up immediately. It’s this function that’s causing us to have all time record levels of cash right now.
Bernard: What does that mean for the market?
Fisher: Normally, the earnings yield in the market has been below the bond yield because there’s been a presumption of future growth. When you buy a bond and you hold it for ten years, you get the ten-year bond rate. But when you buy the market and you hold it for ten years, you don’t get today’s earnings yield. You get the average of future earnings. Since there’s some growth, the future average earnings yield is higher than today’s earnings yield.
Starting in 2003, for the first time in every major country, the earnings yield is above the bond yield. This process allows companies to borrow long-term debt to buy back their stock or take over their competitor. This makes their earnings per share go up. It’s this feature that’s driving the market today. People don’t understand.
Interesting. A bit more byzantine than I can deal with. Let’s see if I have this straight. Gyrating Gizmos (GGI) is selling for $1 a share and is earning 6 cents a share. So, it borrows money at 6% which is really 4% because interest is deductible (except in bad years because you can’t reduce taxable income below zero) in order to buy its own shares which it retires. That causes its stock price to rise, its book value to drop, and it earnings per share to rise And it puts an obligation on the books (the loan) that has to be be retired out of future earnings. Surely that has to show up somewhere .. surely.
Too complicated for the likes of me. It almost seems like the only thing you CAN calculate is the PE ratio.
What this describes is the entire Leverage Buy Out (LBO)movement. But in them after the stock price rises the owners sell, take their leveraged profits,and leave the new owners with the problem of dealing with a firm that now has too much debt. That is how Romney made his fortune.
***What this describes is the entire Leverage Buy Out (LBO)movement. But in them after the stock price rises the owners sell, take their leveraged profits,and leave the new owners with the problem of dealing with a firm that now has too much debt. ***
Are you sure — absolutely sure — that capitalism can not survive without this crap? If it might, I’d sure like to try it and see how things go.
The basic features of modern financial capitalism have been in place since about 1850 — fractional ownership, professional management, viable capital markets.
For most of the time it worked well without the extremes that have developed over the
last quarter century. I agree that we could do well without this crap.
Remember, the best performance of modern capitalism was the 1945-1980 era of big government and tight regulation. Note that since we deregulated the S&L’s in 1980 we
have experienced one after another of these free market industries self destructing.
You forgot one key feature of modern capitalism…limited liability. Take away limited liability and you take away a lot of the risky behavior that motivates CEOs.
2slugbaits — you are right, but it is something I include in fractional owership.
If you bought in 1980 when P/E was low, and held to 1999, when it was high, you made big bucks. If you bought in 1999, you’re still way behind. “Fair value” ain’t got much to do with it – and it ain’t 1980.
Very interesting thanks. I believe there’s even more that could be on there! keep it up