The wonderful DShort.com blog has a post, Is the stock market cheap?, examining the S&P500 using Benjamin Graham’s P/E10 ratio. Doug Short describes the raison d’être of the Graham P/E10 ratio thus:
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. … The historic P/E10 average is 16.3.
Here’s the chart from DShort.com to April 1st:
So what is the P/E10 ratio now saying about the market? In short, the market is expensive. The ratio has entered the most expensive quintile, which means it is more expensive than it has been 80% of the time. What are the implications for this? In his most recent Popular Delusions (via Zero Hedge), Dylan Grice has provided the following chart setting out the expected returns using each valuation quintile as an entry point:
Grice says:
If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.
Doug Short has a more frightening conclusion:
A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its tenth year.
Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations doesn’t encourage optimism.
[…] discussed the Graham / Shiller PE10 metric before (see my April 9 post Graham’s PE10 ratio). In that article, Doug Short described the PE10 ratio thus: Legendary economist and value investor […]
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Does the market as a whole matter? There will always be individually cheap, misunderstood companies. They may become harder to find, but that only further separates the value investor from the crowd.
It would be ironic to join the pessimistic herd and give up the search based on an overall assessment of a magic ratio. How important is the entry point in the long run?
Good luck to bottom-up investors!
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Kai,
Your question got me thinking so I consulted my copy of The Intelligent Investor (Zweig’s 2003 revised edition).. On page 206 Graham states, “On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, EXCEPT when the general market level is much higher than can be justified by well-established standards of value.” However, in the very next sentence he adds, “If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities.”
I am inclined to follow his first notion however, despite his additional statement, due to the post regarding a back-test of a net-net portfolio which illustrated that you’d pretty much be on the streets if you happened to start investing in net-nets at particular times. Although I couldn’t track it down in my brief look, I recall a figure of about 20 being the highest P/E multiple one should invest at. Above that is becoming dangerous. For this reason and those outlined earlier, at the present ‘general market level’ of 21.8, I am hesitant to commit any significant capital.
Finally (sorry for the length here) another indicator Graham identified which I would like to see Greenbackd cover is encompassed in the following statement.. (p.142) “One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many mdeium-sized companies with a long market history.”
Michael
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[…] preferred metric for figuring out whether we’re headed for disappointment is Graham’s PE10 ratio (via greenbackd). I’m not particularly good at timing turns on bull markets or bear […]
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[…] Click Here To Read: Greenbackd: Is The Market Cheap- Graham’s P/E10 ratio […]
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It is very difficult to stay on the sidelines when equities are raging. Especially watching folks around you who are fully invested make money can be difficult if you have a bearish stance.
Having said that, I was around when the tech bubble burst and then we all witnessed the latest fiasco in 2008 and early 2009. My advise is to not worry about the lemmings. Lemmings make money together and then crash and burn as a group.
A value investor can stand alone. He does not crave to be part of the crowd. Be that guy.
Best
FF
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One thing that this doesn’t take into account. Is that earnings take out operating costs.
Paying back the Billions owed to the government, will rig the P/E10 results for the short term, while after its paid back, it will move straight back into the earnings.
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This is interesting, and I am willing to admit that this implies we are not at a good entry point for getting into the market.
Can this serve as a sell signal though? Take a look at the strategy of buying when the price declines into the bottom quintile and selling when it reaches the top quintile. (This assumes you could actually know where the quintiles were before observing the subsequent stock prices.)
You would be in the market
1906-1928 (got in way too early)
1931-1936 (you reach for the falling knife too early)
1942-1965 (actually a pretty good run)
1975-1992 (you don’t participate in the later 90s rise and remain out of the market today. 1992-2010 is a time period that you would be missing out on.)
This strategy does make money, but it does result in missing significant periods of appreciation by entering the market too early and leaving too late. I would be interested in measuring the returns of this strategy based on the numbers rather than my eyeballing.
I would also be interested in:
1. including dividend returns. Because the strategy involves being out of the market for significant periods, we should make sure that lost dividends are considered before crowning this strategy a winner.
2. Consider returns if investments in investment-grade 10-year corporate bonds are made when you are not invested in the market. (Also include bond yields as part of the return.
3. Compare this strategy based on P/E10 to a strategy based on the yield of the corporate bonds rather than the yield of the market.
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Those interested in repeating Mr. Short’s results can easily do so, using public data available from Yale professor Robert Schiller:
http://www.econ.yale.edu/~shiller/data.htm
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[…] the stock market expensive? By this measure, yes. (Greenbackd, […]
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