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A Better Way To Use PE Ratios For Investing

  • Written by Syndicated Publisher No Comments Comments
    July 31, 2014

    There has been an ongoing debate about market valuations and the current state of the financial markets. On one hand, the “bulls” use forward price-earnings ratios to justify current valuation levels while the the “bears” cite trailing valuations based on reportedearnings per share. The problem with both measures is that valuations, at any specific point in time, are horrible portfolio management tools.

    [Note: One of the most egregious fabrications used by Wall Street to try and sell individuals investment products is using forward p/e ratios based operating earnings (earnings before reality) as compared to historical trailing p/e ratios based on reported earnings Read “The Problem With Forward P/E’s” for more.”]

    One of the primary problems with fundamental measures, such as P/E ratios, is the“duration mismatch.” I discussed this issue previously in “When Fundamentals No Longer Matter” wherein I stated:

    “What is truly ironic is that when it comes to buying ‘crap’ we don’t really need, people will spend hours researching brands, specifications and pricing.  However, when it comes to investing our ‘hard earned savings,’ we tend to spend less time researching the underlying investment and more time fantasizing about our future wealth.

    This ‘mentality’ leads to what I call a ‘duration mismatch’ in investing. While valuations give us a fairly good assessment about future returns, such analysis is based on time frames of five years or longer. However, for individuals, average holding periods for investments has fallen from eight years in the 1960’s to just six months currently.”

    stocks-holding-period

    “The point to be made here is simple. The time frame required for fundamental valuation measures to be effective in portfolio management are nullified by short-term investment horizons.”

    It is critical to understand that the current LEVEL of valuations are only useful in determining what the long-term return will be.  John Hussman recently summed this idea up well stating:

    “A widespread misunderstanding comes in when people start using the phrase ‘fair value.’ For any given set of expected future cash flows, if you tell me the price, I can tell you the long-term return, period. If you tell me the long-term return, I can tell you the price, period. Nothing changes this. If you want to say that lower interest rates “justify” a low expected return, and therefore justify a higher price, that’s fine. Just understand that the low expected return will still follow that higher price. If you want to say that in a zero interest rate world, stocks should be priced for zero expected returns over the next 8 years, I have no problem with the conclusion that under that assumption, stocks are at “fair value” here. Just understand that under that conception of “fair value” stocks can still be expected to return nothing over the next 8 years. What is emphatically not true, and not mathematically consistent, is to say that low interest rates ‘justify’ a low expected return, and therefore justify a higher price, but then to turn around and say that since stocks are ‘fairly valued’ under that assumption, they can be expected to achieve normal returns in the future.”

    John is absolutely correct as every bull market in history has ultimately crumbled under the weight of fundamental realities.  This time will be no different. However, rather than arguing absolute valuation levels and future expected returns; P/E ratios can also be used to tell us much about the current trend of the markets as well as major turning points.

    The chart below shows the monthly P/E ratio (using Dr. Robert Shiller’s datagoing back to 1881.

    PE-Expansion-Contraction-072214

    There is something about P/E ratios that is rarely discussed by the financial media which is whether valuation levels are “expanding” or “contracting.” I have noted the major periods of multiple expansions and contractions. (The blue shaded area is the deviation of current multiples from the long-term median.

    I have smoothed the data in the chart above with a 12-month average to better identify the “trend” of valuations as compared to the S&P 500 as shown in the chart below.

    PE-12mthAvg-SP500-072214

    Not surprisingly, we find that periods where multiples are “expanding” are correlated to rising asset prices and vice-versa. Therefore, viewing changes in the direction (or trend)of valuations can provide some clue as to changes in market cycles. This is due to the fact that changes in price (“P”) has a much greater near-term impact on valuations than earnings (“E”). While I am NOT suggesting that earnings are unimportant, changes to earnings move at a much slower pace than price and, therefore, has a muted effect on the directional changes to the overall P/E ratio.  For example, let’s take a look at 2013.

    PE-Changes-SP500-072214

    Over that 12-month period, almost 70% of the increase in the P/E Ratio came from price rather than earnings growth.  The same is true during declining markets when dramatic changes in price have a much bigger impact on valuation changes.

    Importantly, I am NOT suggesting that P/E’s could or should be used as a “market timing” tool.  However, it is quite clear that over shorter-term time frames the directional trend of valuations, rather than the absolute level, is much more telling.

    Currently, the ongoing multiple expansion remains supportive to overall stock prices. This is one primary reason why my portfolio allocation model remains fully invested.  However, this does not mean that you should go “diving” headfirst into the pool either. The low-hanging fruit has already been harvested and, as Hussman noted above,future returns on investments made today are likely to be disappointing

    Forbes also recently penned an article on this very issue providing some additional data.

    “Looking at history, the stock market’s returns depend a lot on where equity valuations are when you start the clock. Ned Davis Research has done the math, comparing the actual levels of the S&P 500 Index each month with a ‘normal’ valuation of the index based on fundamental factors like P/E, dividends, earnings, and cash flows. They identified points when the market was over- or undervalued by at least 20% and they crunched the numbers on performance after each of these points.”

    Ned-Davis-PE-Returns-070714

    “The performance difference is dramatic. On average, one year after a low valuation, the market rose by 19.4%. One year after a high valuation, it dropped by 3.6%. When the market has been fairly valued, it increased 8.0%. Also note the returns one, two, three and five years later. Data through 5-31-2014 shows the market to be 33.240% overvalued.”

    The problem for most investors is the ongoing mistake of chasing short-term market returns at the expense of long-term damage. While it is certainly important to incorporate fundamental measures into asset selection and portfolio construction, the impact of price movement over the short term should not be dismissed. Price is driven by emotion which can create rapid changes to fundamental measures that use “price” as a component.

    Like an inflated balloon, it only takes the smallest of unexpected pinpricks to cause a rapid deflation. Most investors are liking carrying much more portfolio risk than they realize which will only become apparent when it is likely too late to be proactive. Watch for changes in the trend of valuations, it could provide an important clue as to the beginning of the second half of this current market cycle.

    lance sig
    Lance Roberts

    Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of “The Lance Roberts Show,” Chief editor of the X-Factor Investment Newsletter and the Streettalklive daily blog. Follow Lance on FacebookTwitter and Linked-In
     

    Images: via Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.
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