By Dave Anderson:
Is this time really different?
I get scared by those words. Most of the time, this time is just a slightly different flavor of last time. There are very few real paradigm shifts and reality changers. So when I read the following from Barry Ritholtz, I want to find a hole with beer, beans and ammo and pull it over the top of me:
Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line).
The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 � a record high. Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129.
There are a couple of explanations. The first is that current aggregate valuations which make Pets.Com in 1998 look underpriced are truly justified as some how right now it really is different this time. The much weaker claim is that these prices are reasonably well justified because the stock market is an efficient market discounting mechanism and despite the dearth of profits in America right now, profits will return in the near future as cheap money and no regulatory fixes slosh around the economy. The return of profits will lead to a drop in the P:E as prices will stay constant but earnings will greatly increase. Those are the two happy stories that could be told.
The other take on this is to focus more on the price side. If earnings stay flat as consumers are broke and are not borrowing for anything besides core consumption, then the markets are irrational to expect a quick V-shape recovery with associated rapid profit growth. If that is the case, earnings may increase slightly as the cliff-driving holds, but reversion to the historical range will mainly be due to a drop in stock prices. So buh-bye all non-profit endowments, defined benefit pensions and 401-Ks that looked like they are catching a breather in the past six months.
It could be different this time, but I doubt it.
Looking at P:E during a recession, depending on the individual stock but in a general sense, is not very realistic. Looking at price to asset base is much more meaningful, especially when evaluating that base over a period of time. When you buy stock, you are buying ownership in the company and are, in effect, becoming an owner of a portion of its current assets.
ReplyDeleteAssets are a more stable evaluation of the "real" value (as in "real property" or "real estate") of the stock you are purchasing. Earnings may be depressed due to something as temporary as a loan loss write-off, or elevated by equally artificial means.
The craze for buying & selling stock based on P:E is part of the a) business failure rate and b) insanity of executive pay structure, both due to focus on short term profit numbers in order maintain stock prices. Witness GE actually "borrowing" from future profits in order to inflate current profits just prior to its chief executive leaving, raising its stock price based on earnings and fattening his bonus.