State of the market

Buy low, sell high

The median ten year price earnings ratio of all the companies on the London stock market is 16, which is above the median for the period of 14 so shares are perhaps a little pricey.

Comparing the prices of companies to their profits averaged over long periods of time gives a better indication of the value of companies than using one year of profits. That’s because the ten year average is more representative of a typical year, including as it does good years and bad, and at least one full business cycle.

My measure is rough-and-ready, though, as it undervalues past earnings, which ought to be calculated in today’s money (adjusting for inflation) for comparison with today’s price. Also the PE’s of individual companies are not weighted, so the earnings of Vodafone have the same weight as the earnings of a tiny company at the other end of the range.

I started measuring the long-term price earnings ratio of all the companies in the UK market in December 2007, just after the FTSE All-Share had peaked in the autumn. So the chart shows what happened to stockmarket valuations for almost the entire bear market (and subsequent recovery).

The stockmarket as a whole was in bargain territory between November 2008 and March 2009 when shares cost less than ten times earnings, reaching a low of eight times earnings.

Although it might not have felt that way in late 2008, when the stockmarket was plummeting, buying shares when valuations are low is safer than buying them when valuations are high.

Following this valuation chart gives me confidence when shares are cheap, and makes me cautious when shares are pricey.

On the other hand price charts do the opposite: Spooking investors into selling when prices are falling, and breeding over-confidence when prices are rising. If they’re not careful, investors who follow price charts end up selling low, and buying high.

A brief note about the chart: You may be wondering about the blue line and the green line. I started calculating the market PE by averaging the individual earnings histories of all the companies listed in London however long those earnings histories are, up to nine years. The 1 to 9 year PE (blue line) therefore includes companies with only a one year earnings record, or two years etc. The 10 year PE (green line) is a pure long-term ratio, but since most companies have been listed more than ten years, in practice the ratios are very similar.

Now that I’m comfortable that the two lines track each other consistently I’m going to discontinue the blue line and only the green line will go forward because it’s easier to calculate.

A proper inflation adjusted Cyclically Adjusted PE, like those calculated for US markets using data from Robert Shiller, would probably be a better indicator of the value of the UK market, but sadly I lack the data to compute it!

The data used in the calculations comes from the Sharelockholmes.com and Sharescope databases.