Monday, May 11, 2009

Price to Earnings Ratio

I think this is a great article.
Since the stock market's March 9 low, the S&P 500 rose from 676.53 to 929.93 and the Dow Jones industrials jumped from 6,547 to 8,574 by May 8--gains of 37.5% and 31%, respectively. Such stunning gains encouraged bears to dust off the same argument they used two months ago to predict the S&P 500 could fall to 500 and the Dow to 5,000.

A May 11 Wall Street Journal headline claims, "By Most Measures, Stocks No Longer Look Cheap." In this article, Tim Lauricella alludes to three measures of valuation: a trailing ratio of S&P 500 stock prices to operating earnings over the past 12 months; a forward ratio of stock prices relative to estimated earnings over the next 12 months; and a nostalgic ratio of stock prices to a 10-year history of inflation-adjusted earnings. The latter is thought to be "the most widely followed of these barometers ... created by Yale Professor Robert Shiller."

The trouble is that such valuation measures were also cited in a March 9 Wall Street Journal front page feature--"Dow 5,000? There's a Case for It" by Annelena Lobb. "Looking solely at valuations," she wrote, "the S&P at 500 isn't necessarily a wild stretch."

Relying on Professor Shiller's valuations, Barrons' March 7 cover story claimed, "the Dow could fall a further 25%, to 5,000, and the S&P could drop to about 500." In a March 12 commentary on Forbes.com, Nouriel Roubini used forward P/E ratios to predict that "even in the best scenario" the S&P was unlikely to exceed 500-600 this year. The following Sunday, TheNew York Times posted Shiller's chart emphasizing that the ratio of stock prices to earnings "hasn't fallen as far as the market bottoms of 1932 and 1982."

By March 23, after the DOW had risen 14% from the bottom, Mark Gongloff's "Ahead of the Tape" column in The Wall Street Journal suggested "such rallies are fairly typical of the worst markets." He compared it to other "dead cat bounces" between 1929-32. Relying on Shiller's figures, Gongloff said "the S&P is priced about 13 times earnings. ... But that ratio has fallen below 10 in the grimmest bear markets. ... A 30% plunge in the S&P to 530 would take its P/E ratio to 10 in a hurry."

All of these gloomy projections of falling stock prices have been based on falling valuations, not falling earnings. We're told the ratio of stock prices to earnings could supposedly fall below 10 simply because that happened before, in years like 1982.

But stock valuations are not just a matter of opinion, gyrating unpredictably between waves of optimism and pessimism. On the contrary, the graph shows that P/E ratios mainly depend on interest rates. It makes that point by simply turning the P/E ratio upside down, resulting in an earnings-price ratio or "earnings yield."

The previously mentioned New York Times graph highlighted the fact that the P/E ratio briefly fell to seven in early 1982, which is equivalent to an E/P ratio of 14.3 (one divided by seven). My graph, however, reveals that such a low multiple (high E/P ratio) made sense in January 1982 only because the yield on 10-year Treasuries was 14.6%.

sandpratio_graph.gif

This graph bases the earnings-price ratios on trailing earnings over the past four quarters rather than relying on analysts' estimates of the future or on Shiller's decade of ancient history. I used annual figures from the Economic Report of the President for 1980-88 because quarterly data from the Standard and Poor's Web site don't go back that far. After 1988, bond yields in the graph are for the last month of each quarter because that captures changing rates better than a three-month average.

Since 1960, the yield on 10-year Treasury bonds averaged 6.68%, while the earnings yield averaged 6.43. The earnings yield on stocks rarely deviates much from the coupon on bonds partly because stocks and bonds compete with each other, and because stock prices gauge the discounted present value of expected earnings. Expectations of future earnings differ from recent reported earnings, of course, yet nonetheless involve estimating changes from that starting point.

Note that the E/P ratio was lower than bond yields toward the end of the recessions of 1991, 2001 and 2008. That is because trailing earnings are an increasingly bad indicator of future earnings as recessions near an end. Year-to-year comparisons of earnings become easy to beat during the early stages of recovery.

The relatively low E/P ratio in 1999, despite a rising bond yield, does suggest some unduly euphoric momentum, though scarcely a "bubble." Conversely, the E/P ratio was higher than the bond yield in 2005-2006, suggesting prescient pessimism about future earnings but also accurate optimism about rising bond prices (falling yields).

It is not hard to envision future earnings disappointments as a result of higher tax rates on companies or shareholders, health care price controls or cap and trade schemes. But these are threats to earnings, not to multiples. They are to some extent reflected in the weakness in stock prices ever since the election.

Any big drop in P/E multiplies, by contrast, requires a big increase in bond yields. It is certainly possible to envision massive federal borrowing and aggressive Fed easing culminating in a sizable increase in long-term interest rates. Yet such a future of "reflation" and "crowding out" presupposes faster growth of overall demand, gross domestic final sales. In that case, earnings would be rising so the net effect on stock prices might well be positive. Bearish economists, by contrast, typically assume depressed demand and deflation--forecasts impossible to reconcile with the double-digit interest rates required to push the E/P ratio to 10 or more.

I first met Bob Shiller in the early 1980s, when I invited him to speak at Lew Lehrman's Institute in Manhattan. He thought stocks were grossly overpriced then too. Indeed, Shiller always seems to see the current P/E ratio as too high relative to some historical average. But the stock multiple is not a mean-reverting series. On the contrary, the height of today's P/E ratio relative to the past tells us nothing except that (1) interest rates are far below average and (2) future earnings are very likely to rise from today's depressed base.

Unless those who have spent the past two months predicting P/E ratios of 8-10 are also predicting a tripling of long-term rates, their forecasts of stock prices are inconsistent and unworthy of the slightest attention.
Source: Forbes.com

27 comments:

  1. We all heard the worst news about the stock market from analysts and economists but at the end of the day, the market did not slumped, not even close to what they have predicted. It could only mean that even if the market has received a hard blow from the recession, it is thriving. Yes, the market is volatile but it offers many great deals. Lucky for those investors who have grasped the unprecedented investment opportunities the markets is currently giving.

    ReplyDelete
  2. Weeks time 2 within intensive care. It appears to be while in case a burial can come before the montreal canadiens jerseys full week is over. Michael preserves nagging with regards to singing to his / her drew brees jersey sibling, however youngsters are never granted within Intensive Proper care. However cheap nhl jerseys Karen comprises your girlfriend mind. She'll consider Jordan whether or not they will like it as well as possibly not.

    ReplyDelete
  3. I like concept of your post. Very creative post. Best of luck and waiting for some new ideas. I am looking for such useful information and I found here a lot of it.
    Commodity tips
    Stock Market
    Share Market
    Nse Tips
    Bse Tips

    ReplyDelete
  4. Really good site thank you so much for your time in writing the posts for all of us to learn about. It will be very useful for me.
    share market
    stock market
    Indian Stock Market Tips

    ReplyDelete
  5. This is a great post ! it was very informative. I look forward in reading more of your work.
    Intraday Nifty Future Tips
    Share market tips
    Share and Earn

    ReplyDelete
  6. Hi! Do you use Twitter? I'd like to follow you if that would be ok. I'm undoubtedly enjoying your blog and
    look forward to new posts.

    Here is my blog post Sjhani.Com

    ReplyDelete
  7. I don't know whether it's just me or if everybody else experiencing problems with
    your blog. It seems like some of the text within your posts are running off the screen.
    Can someone else please provide feedback and let me
    know if this is happening to them too? This may be a issue with my web browser
    because I've had this happen previously. Appreciate it

    Here is my site ... home business for dummies

    ReplyDelete
  8. Pretty nice post. I just stumbled upon your blog
    and wanted to say that I've truly enjoyed browsing your blog posts. After all I'll be subscribing to your
    rss feed and I hope you write again very soon!


    Check out my page: akribos watches

    ReplyDelete
  9. I tend not to leave a bunch of comments, but i did a few searching and wound up here "Price to Earnings Ratio".
    And I actually do have a few questions for you if you tend not to
    mind. Is it only me or does it give the impression like some
    of the comments come across as if they are left by brain dead folks?

    :-P And, if you are writing on other places, I would like to follow anything new you have to post.
    Would you make a list of all of your community pages like your
    twitter feed, Facebook page or linkedin profile?

    Here is my web-site http://www.art-nation.ru

    ReplyDelete
  10. I believe this is one of the most vital information for me.
    And i'm happy studying your article. But want to statement on few common things, The website style is perfect, the articles is in reality excellent : D. Just right job, cheers

    Also visit my blog: Mens watches

    ReplyDelete
  11. Excellent way of explaining, and good post to obtain facts about my presentation subject, which i
    am going to convey in college.

    My web site; stop body hair growth men

    ReplyDelete
  12. Generally I do not learn post on blogs, however I wish to say
    that this write-up very compelled me to try and
    do so! Your writing style has been amazed me. Thank
    you, very nice article.

    Here is my blog: daddysgarage.org

    ReplyDelete
  13. You're so right about chia pudding taking practice...I truly feel like it's by no means the identical twice!
    I've absolutely found giving it a whirl inside the food processor achieves the texture I prefer, so I'll give it the further step and clean up.
    Still easier than cooking oats, and it's an excellent breakfast when it really is warmer out also!

    Have a look at my blog :: Organic Chia Seed

    ReplyDelete
  14. Hi, I do think this is an excellent site. I stumbledupon it ;) I may come back yet again since i
    have book marked it. Money and freedom is the greatest way to change, may you be rich and continue to guide other people.


    Here is my blog post: pro solution male enhancement gel

    ReplyDelete
  15. Link exchange is nothing else however it is just placing the other person's weblog link on your page at suitable place and other person will also do same for you.

    Also visit my site - ultra hair away

    ReplyDelete
  16. Wow, marvelous blog layout! How long have you been blogging for?
    you make blogging look easy. The overall look of your web site is wonderful, as well as the content!



    Visit my site; remove cellulite from legs naturally

    ReplyDelete
  17. Remarkable! Its truly awesome article, I have got much clear idea on the topic of from this post.


    Here is my weblog ... Insomnia Synonym Antonym

    ReplyDelete
  18. What's Happening i'm new to this, I stumbled upon
    this I've discovered It absolutely useful and it has aided me out loads. I'm hoping to
    contribute & help other users like its aided me.
    Good job.

    My website ... skinception demefface

    ReplyDelete
  19. Just what could you be dudes talking about?

    Feel free to surf to my weblog :: key-personnel.com

    ReplyDelete
  20. I'd like to thank you for the efforts you've put in penning
    this site. I really hope to view the same high-grade content by you later on as well.

    In truth, your creative writing abilities has
    inspired me to get my own, personal site now ;)

    Here is my web page; mouse click The up coming post

    ReplyDelete
  21. In most cases bendable given that lessens here
    we are at reducing veggie's plus rewards immediately faster bits. Championed in enthusiasts because of immortalized margaritas with the incomparable top quality regarding blizards they can present, Margaritaville machines put in a fantastic system of ensuring your upcoming home-grown frozen cocktail is truly of those maximum high quality. With people yellow, you very often achieve regarding 50 % of magnifying glaas related to white liquid. Obtainable masticating juice machines designed to veggie juice a large percentage of food stuff all of which will rather than juices hemp grass lawns. Rattles produced featuring dairy products also homegrown fruit then glaciers.

    Check out my site :: oster blender bccg08 replacement jar

    ReplyDelete
  22. Yes, thats really what I sought-after to get a hold of
    out! The information and the facts were simply consummate.

    we imagine that your particular view is on track,
    the simply well thought out and really wondrous to
    observe someone whom understands simple tips to invest these thoughts down therefore well.
    Awesome job.

    Also visit my web-site ways to make money online []

    ReplyDelete
  23. Today, I went to the beach front with my children.
    I found a sea shell and gave it to my 4 year old daughter and
    said "You can hear the ocean if you put this to your ear." She placed the shell to her ear and screamed.
    There was a hermit crab inside and it pinched her ear.
    She never wants to go back! LoL I know this is completely off topic
    but I had to tell someone!

    My web-site; simply click the next web page (http://yahooarticles.info/article.php?id=16294)

    ReplyDelete
  24. Depending upon the structure, a small amount of burst quite easily.
    Customers solution too absolutely these people breakdown or even
    divider, opening all the nutritional, vitamin
    antioxidants but phytonutrients for you to simply nibbling without help can never
    performed. Avoid using personal mixer hobbies involve weakened,
    is suffering from a tainted court, together with sparks considerably more
    put on. Imagine about this particular.

    Feel free to surf to my blog :: ninja 1000 professional blender review

    ReplyDelete
  25. Hmm it appears like your blog ate my first comment (it was extremely long)
    so I guess I'll just sum it up what I had written and say, I'm
    thoroughly enjoying your blog. I too am an aspiring blog writer but I'm still new to the whole thing. Do you have any tips for newbie blog writers? I'd definitely appreciate it.


    my page weight loss supplement ()

    ReplyDelete
  26. Cleaning having rock bear hair did not fully check with anyone, nor managed flavored raunchy noxious chemicals.
    Prepare and prepare exceptional healthy foods your household
    and even passengers will love. An important reason of toaster ovens
    ought to be to salute bread (but they deal with numerous responsibilities).
    You are able to mask it all note down anytime. A particular gardening equipment a wonderful gas stove in the the baking necessitates, it is
    recommended make aspect in the affair accessible. And you also also know
    very well?

    Look into my blog: russell hobbs toasters at argos

    ReplyDelete