June 6, 2014
By Steve Blumenthal
One of the more challenging debates in our business is tied to the proper use of P/E (price/earnings) as a valuation measure. One expert says P/Es are low, pointing to forward earnings estimates. The other says P/Es are high. Buy at bargain prices or overpay? You can find both views on the same day. Who’s right?
It all comes down to how one measures earnings. Some favor Wall Street’s forward earnings estimates while others favor valuations based on actual reported earnings. Some smooth earnings over time and others don’t.
I do not believe that valuation is a timing tool (it is actually a poor timing tool) but I do believe it to be a useful measure of underlying market risk and potential reward. Simply, when valuations are low, there is less risk and more reward. When high, more risk and less reward.
I attempt this week to cut through the P/E fog and talk about how to view return and risk through the lens of P/E. In this way, history can provide a clue. The ultimate goal is to risk protect your equity in periods of time when forward returns look small (and risk high) and reweight your portfolio more aggressively when forward return looks large (risk low).
So let’s take a look at several different P/E valuation measurements to get a sense of where we are today and what this suggests about forward returns. Ultimately, the goal is to use the information to better shape portfolio positioning.
I highlight the following in this week’s On My Radar:
- The P/E Report: Ed Easterling’s Quarterly Review Of The Price/Earnings Ratio
- Median P/E Through May 31, 2014
- S&P and “Normal” Valuation and Price to Sales
- Trade Signals – Temperature Rising
The P/E Report: Ed Easterling’s Quarterly Review of the Price/Earnings Ratio
I’m a long-time big fan of Ed Easterling’s work. In his most recent quarterly P/E update, he does a great job at explaining the nuances that surround P/E. Following is an excerpt. Below I provide a link to the report.
“The P/E ratio can be a good measure of the level of stock market valuation when properly calculated and used. In effect, P/E represents the number of years’ worth of earnings that investors are willing to pay for stocks. Although we will discuss later the business cycle and its periodic distortion of “reported” P/Es, most references to P/Es in this report will relate to the normalized P/E that has been adjusted for those periodic distortions.
Stocks are financial assets which provide a return through dividends and price appreciation. Both dividends and price appreciation are generally driven by increases in earnings. Despite the hope of some pundits, earnings tend to increase at a similar rate to economic growth over time.
Historically (and based upon well-accepted financial and economic principles), the valuation level of the stock market has cycled from levels below 10 times earnings to levels above 20 times earnings. Except for bubble periods, the P/E tends to peak near 25 (the fundamental limitations to P/E are discussed in chapter 8 of Unexpected Returns). Figure 1 presents the historical values for all three versions of the P/E discussed in this report.
What drives the P/E cycle? The answer is the inflation rate—the loss of purchasing power of money and capital. During periods of higher inflation, investors want a higher rate of return to compensate for inflation. To get a higher rate of return from stocks, investors pay a lower price for the future earnings (i.e. lower P/Es). Therefore, higher inflation leads to lower P/Es and declining inflation leads to higher P/Es.
The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings (the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.
Therefore, for this discussion, assume that there are three basic scenarios for inflation: rising, low, and deflation. As discussed above, rising inflation or deflation causes the P/E ratio to decline over an extended period which in turn creates a secular bear market. From periods of higher inflation or deflation, the return of inflation to a lower level causes the P/E ratio to increase over an extended period thereby creating a secular bull market.”Source: Crestmont Research
The historical average for normalized P/E is 16.3 based upon reported 10-year trailing real earnings (the method popularized by Yale professor Robert Shiller). Easterling takes a different cut at valuation and comes to a somewhat similar number today. Both Crestmont and Shiller’s P/E measures are greater than 25 reflecting a very expensively priced market.
I know some, including Wharton professor Dr. Jeremy Siegel, challenge Shiller P/E. The point I’d like to make is that it is in the comparison the current P/E (calculated by any process, whether it be Shiller, Easterling, etc.) to its historical norm (of that same process) that should be measured. Inflation and deflation impacts margins. Economic expansion and contraction happens. Earnings expand and contract.
I think projecting today’s record profit margins into the future is a risky bet. I think looking at Wall Street’s forward estimates to calculate P/E is a mistake. That argument might say P/Es are fairly priced. The problem is Wall Street’s bad habit of being overly optimistic on corporate earnings. In my view, real reported earnings and comparing those earnings to that same historical data set is best. In this way, you can get a feel for whether you are buying at a discount or paying a large premium. Some form of normalization of P/E, to me, makes better sense. Except for Wall Streets forward estimates or recent quarterly results (both of which I believe a mistake to follow), I can’t help but see an overpriced market today.
Here is the link to Ed’s full report.
NDR Median P/E Based on Last 12 Months of Reported Earnings
While Easterling and Shiller smooth their data over longer periods of time, in the next chart NDR looks at median P/E based on the last 12 months of real earnings. As of May 31, it shows the market about 19.3% above fair value.
The bottom clip in the above chart represents the Standard and Poor’s 500 Stock Index Median Price/Earnings (P/E) Ratio, which represents the median P/E of the 500 stocks in the Standard and Poor’s 500 Stock Index universe. Earnings for this calculation are based on 12-month trailing figures.
This view shows the market as not as overpriced as Crestmont and Shiller but overpriced non-the-less. In my view, the chart does a good job in setting a probable upside and downside target for the S&P 500, and shows median fair value at 1553.11. Nearly 20% lower than where we are today. Mark that point as an attractive entry level should an anticipated summer correction unfold.
The bet is on the continuation of record profit margins going forward. Here, too, caution is advised.
S&P and “Normal” Valuation
In the next data set, a normal valuation line is created looking at the historical data on dividends, earnings, cash flow, sales, CPI-adjusted inflation and trend. The dotted black line takes the median of those calculations each month going back to the 1920s.
Note the outsized returns when buying into the market below -20.0 and the poor returns when above 20.0 (red arrow). Yellow circle highlights where we are today.
Price to Sales
The following is a look at median price/sales ratio for the S&P 500 stocks: This paints perhaps an even more overvalued picture. I can’t help but believe that unconventional Fed policy has inflated asset prices to a point of very high risk.
One last thought on earnings. They move all over the place as noted in the next chart: S&P 500 EPS 1950 to present. Be careful not to project today’s record profits too far forward. They have a habit of mean reverting and a normal occurrence over a healthy business cycle.
Trade Signals – Temperature Rising
In Trade Signals, we take a look at the most recent investor sentiment and market trend data. In short, the cyclical trend remains bullish for both the equity and fixed income markets. Sentiment is back to extreme optimism (hedging is advised).
Despite relatively high valuations, the primary cyclical trend remains favorable. The cyclical trend remains positive as measured by Big Mo and the Fed remains supportive for now (as in don’t fight the Fed or the Tape). However, caution is advised as the cyclical bull is aged, the market is overpriced and investor sentiment is once again in the Extreme Optimism zone. I continue to expect a sizable summer sell-off and favor hedging your equity exposure and actively managing your bond exposure in a disciplined way (ie: Zweig bond model).
Click here for a link to Wednesday’s Trade Signals.
Conclusion
If, like me, your number one investment goal is to grow your wealth while mindfully protecting against the crises that seem to occur every five plus years or so, P/E can serve as a very useful tool to assess underlying levels of risk (high PE high risk, low PE low risk). Today, we are once again in one of those periods where risk is high.
The good news is that this is relatively easy to accomplish; however, it requires knowledge, a disciplined investment process and, of course, setting aside the time needed to manage the process.
Alternatively, you can find an equity strategy with a tail risk management process built in that can do it for you. Over a market cycle, I believe there is little added expense if executed correctly. Even if there is modest cost, one must consider the cost of overcoming another 50% decline and lost opportunity cost of being in a healthy position to take advantage of the value that the next crisis creates. Plus, it just might be a more peaceful way to grow your assets over time. A great book on this topic is titled Tail Risk Protection. We incorporate a somewhat similar process in one of our equity strategies. The objective is growth with intelligent downside protection. I think it makes sense.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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