While the WSJ is prepared to consign the PE ratio to the dustbin (see The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?) Barry Ritholtz is one of the few actually asking the question, “What does a falling P/E ratio mean?”
Ritholz focuses on the expansion and contraction of the PE ratio as indicative of bull or bear markets:
We can define Bull and Bear markets over the past 100 years in terms of P/E expansion and contraction. I always show the chart below when I give speeches (from Crestmont Research, my annotations in blue) to emphasize the impact of crowd psychology on valautions.
Consider the message of this chart. It strongly suggests (at least to me) the following:
Bull markets are periods of P/E expansion. During Bulls, investors are willing to pay increasingly more for each dollar of earnings;
Bear markets are periods of P/E contraction. Investors demand more earnings for each dollar of share price they are willing to pay.
Hence, a falling P/E ratio is not indicia of its lack of utility. Nor is it proof of “Fustyness.” Rather, it suggests that crowd is still feeling burned by the recent collapse in prices and increase in volatility.
Here’s the chart:
I think Ritholz’s analysis is excellent as far as it goes, but I think it misses part of the story. The “E” in the PE ratio is also subject to expansion and contraction over the course of the business cycle. Earnings are still normalizing from a period of massive expansion. While the single-year market PE might be at 15.8, which is a little over the long-term average of 15, on a cyclically-adjusted basis, the PE ratio is over 20, which is historically expensive:
Assuming that this time is not different, earnings will contract as they regress to the long-term mean, and the market PE ratio will contract along with earnings.
The best analysis on PE expansion/contraction is John Mauldin’s Bulls Eye Investing where he cites Ed Easterling’s work (he has his own book as well and is the Crestmont Res BR cites). It’s all about secular bull and bear markets.
Vitaliy Katsenelson recreated the wheel in his book regarding these markets as well.
In the secular bear market we’re in, we can have earnings growth but no PE expansion meaning the companies “grow into” the new PE. Maybe they grind down to a 6x P/E or whatever in aggregate but they can still have earnings growth but due to a broader market overhang, nothing happens.
GE for example grew EPS at about a 12-15% clip in the late 70s and the stock went nowhere meaning its P/E went down. Only until we had a rising tide to help them out from 1982 did the stock take off.
When you’re in this type of market, I think the best investing style is buying stuff with a few catalysts, that are dirt dirt cheap (cause then you can still get legit valuation multiple expansion), and have slightly lower market exposure.
LikeLike
Margins will not necessarily revert to “the” mean
– the US is more heavily based to industries with intangibles that the manufacturing USA of the 50s. Less capex higher ROEs
– corporate balance sheets are very strong and accumulating cash. A FCF/EV would probably be more appropriate
– Same goes for Tobin’s ratio
That is why I think it is important to invest bottom-up. This macro views should be kept just as a hobby to avoid distorting the views of what is happening in the real world. Anyone that has analyzed for example Google, Pepsi, JNJ, Wellpoint, Pfizer, Bank of America, and several other big caps cannot say that the market is expensive today.
Grantham also made a comment with the tone that if margins do not revert that means the end of capitalism. That is also not necessarily true. That capitalist class is more now of a widespread creative class: bankers, consultants, athletes, movie stars,…
LikeLike
So you’re saying, “This time is different”?
LikeLike
No, I am saying that you chose the wrong metric to mean revert. The margins in 1870 (capital intensive railroads) are different than in 2010.
LikeLike
Greenwald kind of makes the same point about reversion, citing perfect competition as an economic model to understand why without barriers to entry, any excess profits will be temporary. If there are no barriers to entry, any firm can enter and take away those excess profits (it’s a level playing field).
Just because we have a more widespread creative class doesn’t mean that they’re not subject to perfect or mostly perfect competition. Some of them probably are not subject to competition (celebrities perhaps?) but plenty probably are (Broadway actors, maybe the masses of sitcom actors, etc, perhaps writers).
At the end of the day though, given the function competition plays in capitalism, if margins don’t revert, that means there isn’t enough competition (competitive advantages are not widespread, isn’t that so?) trying to take away market share and excess profits. Without such competition, how much innovation will there truly be? And so I can see that leading to the conclusion that capitalism would be dead.
LikeLike
It is an interesting point Ameet, ROIC in capital intensive industries should mean revert, that is the whole point of the invisible hand. But what happens when the IC does not include intangibles like brands (KO), relationships (GS or other creative industries) or other moats? And where is the analysis of the balance sheet and the cash available (MSFT, AAPL, Cisco, GOOG)? The first is Buffett’s point of quality of earnings and the second is Graham of analyzing the balance sheet, nothing earth shattering for people reading this excellent blog.
Most people I talked about this see the regression and say that the last 50 year have been expensive for the most part. But where should you start the regression, why not 1958 when Bufett started investing and he had more ideas than cash? Or maybe the P/E is not the right metric, why not owner’s earnings or add a ROIC component?
Actually, if you see the corporate earnings share of GDP (the E part of the equation) is not precisely mean reverting the last 30 years. There are five options:
1.you believe that more people are sharing the wealth
2.you believe that there is going to be social pressure to regulate or share those profits (like the shorts of healthcare or private education)
3. You believe that we are are still too far from reaching the social breaking point and no need to worry for now (more wealth)
4. you believe that the system is broken (Grantham’s worry but not necessarily what he believes)
5. you believe that there is an invisible something that will restrain it (and it has not been competition until now)
I suggested #1 (creative class and management) and believe part of #2 and #3 are also going on. But I am not a sociologist or an economist so maybe Greenbackd and Greenwald and others are correct in #5, but if that is the case I have not seen data supporting it … just a believe.
As an investor it looks more easy to invest bottom up than play the sociologist game, and if you look the S&P there are so many opportunities.
LikeLike
Plan,
I can’t help but think that even for companies right now with competitive advantages like those you list, we will see their earnings degrade as their competitive advantages fade away. Though when, I don’t know.
However, that is an empty phrase without some data.
From the top down, I think the PE10 of the S&P 500 is a good data point for general market expensiveness. I think it is an even better data point for determining whether it would be asinine to buy the S&P 500 index, since that is what it is measuring, not the market as a whole.
Within the S&P 500, I happen to agree with you that looking from the bottom up will probably result in a good portfolio of cheap, quality companies even if the index they are comprised of is expensive. It is more easy to look from the bottom up, I agree. I honestly wonder if a lot of top down discussion is because investors felt blindsided by 2008 when even the equities they thought were cheap (and perhaps they were) suffered along with everything else, which could have been avoided by looking from the top down, declaring the S&P too expensive, and holding cash. Though the question there should be how often has a top down view helped in mitigating risk versus a bottom up view that will inevitably suffer periods of loss.
Though for those who start fund, at some point or another they’ll probably be faced with investors wanting to know their view on the economy and the stock market in general. Your answer about ultimately caring about a bottom up view for your portfolio is probably fine. And in the mean time, hopefully we all can expand our knowledge with this discussion.
I believe #5, incidentally, from your point of view, though I don’t think I could call the erosion of competitive advantages of certain companies to be mean reversion, if and when it occurs. But overall, my belief is rather empty since I can’t cite for you any data at the moment. My apologies for that.
LikeLike
Your point on investors expecting from their asset managers a market perspective is a good point. At the same time, Charlie Munger has complained that investors expect from their managers predictions on many things that are not conducive to investment results.
I do some top down analysis concentrated on leverage and financial system health but that is probably more risk management than valuation. But when you are not in scary valuation lands, general market ratios do not seem to help much in terms of valuation.
For example, another issue that I have been thinking is the reversion to the mean of financials and cyclicals. BUT IT GOES THE OTHER WAY. They represent a large percentage of the S&P and are probably depressing the E making the P/E high (and that may explain why quality stocks look so cheap)
P/E ratios do not work very well for cyclical / turnaround stocks -a Peter Lynch point- but an analysis ex-financials or ex-cyclicals is time consuming and have not seen anywhere. I think Vitaly (ContrarianEdge) made an analysis of margins per sector and that may be helpful.
LikeLike
Interestingly, P/E can be thought of as a special case of discounted present value:
http://gemfinder.com/pe-ratio-and-present-value/
LikeLike