The P/E Report:
An Excerpt From Crestmont Research
By Ed Easterling of Crestmont Research
April 4, 2012
The following commentary and analysis is an excerpt from Crestmont's quarterly review of the price/earnings ratio titled The P/E Report. The most recent update is available at this link: The P/E Report.
CURRENT STATUS (First Quarter 2012)
The stock market increased significantly over the past quarter. As a result, P/E has increased further into the range of "fairly-valued." The reported P/E is distorted well below the normalized P/E due to currently high and unsustainable profit margins. The perception of low P/E valuation is likely providing support for the stock market. If the next downward leg in the business cycle is postponed for another year or longer, and if other economic and international headwinds remain contained, then the market could resurge toward new highs. At the same time, investors should remain cognizant of the risks confronting an increasingly vulnerable market.
THE BIG PICTURE
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 over time. 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.
Figure 1. P/E Ratio: 1900-1Q2012E (EPS estimate from S&P)
Note the significant business cycle divergence in P/E. P/E can send a false signal of undervaluation, even when it is overvalued or fairly-valued. EPS now exceeds the baseline trend; distorting the reported P/E and it may distort further. The current reported P/E of 15.4 may seem near average, yet the normalized P/E stands at a lofty level that is over 20.
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 decline.
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.
Secular bull markets can only occur when P/E ratios get low enough to then double or triple as inflation returns to a low level. As a result, secular market cycles are not driven by time, but rather they are dependent upon distance — as measured by the decline in P/E to a low enough level to then enable a significant increase.
Cyclical vs. Secular
The current P/E is 20.8 — well above the historical market average and well into the range that would be expected in a low inflation environment (assuming historically-average economic growth). BUT, secular markets are driven by longer-term annual trends rather than momentary market disruptions.
The secular analysis for each year relates to the average index across the year; so for each year, the price (P) in P/E (price/earnings ratio) is the average index for all days of the year. The stock market has recovered most of its declines from late 2008 and early 2009; therefore, it's now fairly clear that the period in late 2008 and early 2009 was just a cyclical (short-term) bear market blip within a longer secular bear market. Of course, that makes the last three years a typical cyclical bull market inside a secular bear market (it has happened many times before).
If the stock market does not recover further or cannot sustain the recovery gains from the past three years due to significant inflation or deflation, the normalized P/E over the next few years will likely decline below the historical average and the foundation for a secular bull market would begin to be laid.
We're in a period with many daily (often hourly) pixels. The short-run trends (the cyclical cycles) of the market are hard to predict. Without extraordinary powers of clairvoyance, the best plan is a diversified, non-correlated portfolio with a few engines to counterbalance the weaker components of the portfolio.
BACKGROUND & DETAILS
As described further in The Truth About P/Es in the Stock Market section at www.CrestmontResearch.com, P/E ratios can be based upon (a) trailing earnings or forecast earnings, (b) net earnings or operating earnings, and (c) reported earnings or business cycle-adjusted earnings.
(a) The historical average for the normalized P/E is 16.3 based upon reported ten-year trailing real earnings (i.e., the method popularized by Robert Shiller at Yale). The ultra-high P/Es of the late 1990s and early 2000s were high enough and lasted long enough to significantly distort what we now know to be the average P/E. If those years are excluded, the normalized P/E is almost one multiple point lower (i.e., approx.. 15.5). Further, if forecast earnings is used, the average normalized P/E would be reduced by approximately one multiple point to 14.5. Note that the average reported P/E from 1900 to 2011, unadjusted for the business cycle and adjusted for the late 1990s bubble, is 14.
(b) Substituting operating earnings for net earnings would further reduce the normalized average P/E by almost three points to 11.5.
(c) Although the effect of the business cycle is muted in longer-term averages, the currently-reported P/E varies significantly due to the business cycle (more later).
It is important to ensure relevant comparisons — that is, P/Es that are based upon trailing reported net earnings should only be compared to the historical average of 14. When ten years of real net earnings are used in P/E (i.e., Shiller P/E10), the relevant average is 15.5.
Too often, writers and analysts compare a P/E that is based upon forecast operating earnings to the average for trailing reported net earnings. Although long-term forward operating earnings data is not available, the appropriate P/E for that comparison would be closer to 11.
Yet the most significant distortion from quarter-to-quarter or year-to-year is due to the earnings cycle, or as some refer to it, the business cycle.
The Business Cycle
As described further in Beyond The Horizon: Redux 2011, Back To The Horizon, and Beyond The Horizon in the Stock Market section at www.CrestmontResearch.com (and in more detail in chapters 5 & 7 of Probable Outcomes: Secular Stock Market Insights), corporate earnings progresses through periods of expansion that generally last two to five years followed by contractions of one to two years. The result of these business cycles is that earnings revolves around a baseline relationship to the overall economy. Keep in mind that the business cycle is distinct from the economic cycle of expansions and recessions.
Figure 2. EPS: S&P 500 Companies (1950 to 2012E)
For example, looking back over the past six decades, Figure 2 presents the annual change in earnings historically reported by the S&P 500 companies and forecasted by Standard & Poors. This graph highlights the surge and decline cycle of earnings growth that is driven by the business cycle. Note how the pattern of the earnings cycle — typically two to five years up followed by one or two of declines — appears to again be repeating.... The business cycle is not dead yet.
When the reported amount of earnings is viewed on a graph, the result is a generally upward sloping cycle of earnings growth. Since earnings ("E") grows in a relatively close relationship to economic growth (GDP) over time, there is a longer-term earnings baseline (as discussed in chapter 7 of Unexpected Returns) that reflects the business cycle-adjusted relationship of earnings to economic growth (GDP). Figure 3 presents actually reported E for the S&P 500 over the past four decades compared to the longer-term baseline.
Figure 3. EPS: Reported vs. Trend Baseline (1970 to 2013E)
The past few legs of the cycle have swung more dramatically than it has in the past; will that accentuation continue? Or, will we finally get back to being closer on track? The EPS forecasts for 2012 and 2013 are above the trend-line; history again appears to be repeating the patterns of the business cycle.
Why does this matter? Because if you only look at the P/E ratio reported for any quarter or year, the ratio (with such a volatile "E" as the denominator) will be quite distorted during peaks and troughs when compared to the more stable long-term average. About every five years or so, the reported P/E will reflect the opposite signal rather than a more rational view of P/E valuations. For example, the reported value for P/E in early 2003 reflected a fairly high value of 32 just as the S&P 500 Index had plunged to 800 (E had cycled to a trough of $25 per share). A P/E of 32 generally screams "sell" to most investment professionals; yet, in early 2003, that was a false signal! A more rational view using one of the business cycle-adjusted methods reflected a more modest 18. In a relatively low inflation and low interest rate environment, the scream should have been "Buy"....
Several years later, in 2006 (after an unusually-strong run in earnings growth), E peaked at $82 per share as the S&P 500 Index was hesitating at 1500. Most market pundits were recommending a strong "buy" due to a calculated P/E of only 17. Yet, using the rational business cycle-adjusted methodologies, the true message was "STOP" — P/Es were saying sell, with P/E more than 25.
Well the pundits were actually (sort of) right — P/Es did expand.... Yet it was due to (what should have been expected) the normal down-cycle in E rather than the pundit-promoted increase in the stock market. So when investors' stock market accounts were down almost 50%, they were handed explanations that the earnings decline was unexpected and the fault of the financial sector....
Many of the same pundits are bewildered by current market conditions and unsure about the future of E. Maybe this time will actually be different... or maybe not....
As for the market and P/E, it's understandable that conservative investors and market spectators have watched the past few years with awe. Even so, the current momentum remains upward. Nonetheless, it is important to remain aware that typical market volatility makes it also likely that the market will experience significant short-term swings.
Note: The full version of this report is available here from Crestmont Research.
Ed Easterling is the author of recently-released Probable Outcomes: Secular Stock Market Insights and award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. Further, he is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU's Cox School of Business where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students.
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