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The market is cheap! No! It’s expensive!

Posted on September 21, 2007 by Richard Beddard
Filed Under Markets |

The market’s price earnings ratio is lowish suggesting good returns ahead. But the long-term PE is high, suggesting we’re doomed. Can they both be right?

CXO Blog says shares are good value. Price to earnings ratios remain at or below both their 17-year and three-year averages, with current levels and earnings forecasts suggesting good returns for the market in coming quarters…

…But, lowish PEs now could be the result of outsized profits that might not persist. According to the market’s long-term PE ratio calculated by Professor Robert Shiller, shares are currently expensive. If you divide the price of the market by the average earnings of companies over 10 years, the PE ratio is much higher because of lower earnings in the past. In August it was hovering around 27, compared to a normal PE of 16.5.

So, which PE ratio is right? Both, or neither, it transpires. I emailed Steve Le Compte, who runs the CXO Advisory Group. He said:

By using 10-year measurement intervals, one assumes that the essence of financial markets does not change much over very long periods. For example, a 200-year data sample achieves only 20 completely independent intervals. Given all that has changed with regard to markets, financial instruments and technology in the past 200 years, is P/E really a stable concept over that period?

However, by using short sample intervals to ensure a stable financial environment, one must often accept means [averages] that are small with respect to standard deviations. That means lots of noise (and bad bets).

It seems we cannot win when it comes to finding sure bets.

So, on the one hand we’ve got:

…a short-term forecast that likely reflects the current financial environment but is statistically not very reliable.

And, on the other hand we’ve got:

…a long-term forecast that is more statistically (mathematically) reliable but may include data of dubious applicability to the current financial environment.

But as they’re all we’ve got, let’s assume both PEs are right for a moment. What could it mean? In his blog Steve says:

In general, forecast intervals should be comparable to sampling intervals.

So, could it be that the normal PE based on recent earnings (a relatively short sampling interval) shows the market is cheap, for now, and indicates that it might rise in the near future - this year say?

And the long-term PE, based on ten years of earnings (a longer sampling interval) is signalling the market is expensive relative what would be a sustainable growth in earnings. And the prognosis looks worse in a year, or two - say?

Not being a statistician, I asked Steve. He said:

Your last question is a reasonable conclusion, but it is too black-and-white.

In other words (mine) a respectable statistician and serious research blog wouldn’t draw such sweeping conclusions. A blogger/investor/journalist drawing conclusions on the hop might. Interesting? I’ll let you decide*1.

Perhaps, subconsciously, I’m still digging for data to validate the unscientific and sensational Great Crash of 2009 theory.

Footnotes

  1. Really, I will let you decide. Here’s two of Steve LeCompte’s emails. He’s done a tremendous amount of research all linked here, and I’m grateful for his patience and precision in explaining this:

Richard,

In general, when the mean of a sample is small with respect to the standard deviation, the sample is very noisy. The noise-to-signal ratio is large. You need a large sample to make the noise reliably cancel itself out. The probability that you will get a result near the mean for any one bet is lower than when the standard deviation is relatively smaller. Assuming a normal distribution (not quite right for stock returns), about two-thirds of sample results fall within one standard deviation above and below the mean. See http://www.cxoadvisory.com/blog/internal/blog1-19-07/ for charts on how the relationship between mean return (signal) and standard deviation of returns (noise) varies as the sampling interval increases — the shorter the sampling interval, the higher the noise-to-signal ratio.

The statement about forecast and sampling intervals gets at study design and clarity regarding true sample size and statistical reliability.

Your last question is a reasonable conclusion, but it is too black-and-white. The trade-off is between pure statistical reliability based on sample duration and the risk that there are structural breaks in the relationship between variables under study (regime changes) within the sample. By using a sample of many decades to achieve pure statistical reliability, an investigator risks introducing big changes in the risk-return relationship such as the introduction of new risk-mitigating regulations, financial instruments (e.g., mutual funds) or data processing technology. By using a short sample, an investigator hopes to avoid confounding structural breaks but is stuck with noisy data. For example, the R-squared statistic for the relationship in the second chart at http://www.cxoadvisory.com/blog/internal/blog9-20-07/ is just 0.09, meaning that the P/E at the beginning of a quarter since 1990 explains just 9% of the variation in S&P 500 index returns the next quarter. Other factors explain the other 91% of variation.

So, would you rather have a short-term forecast that likely reflects the current financial environment but is statistically not very reliable, or a long-term forecast that is more statistically (mathematically) reliable but may include data of dubious applicability to the current financial environment?

-

Richard,

Based on P/E alone and data from the past 15-20 years, stocks are currently undervalued. The analysis at http://www.cxoadvisory.com/RTV-details/ applies.

However, P/E is just one simple way to make a rough judgment about equity valuations. P/E tends to fall when the inflation rate rises – it seems that investors demand greater return from stocks (and obviously, bills and bonds) when the inflation rate is high. The analysis at http://www.cxoadvisory.com/REY-details/ adds inflation to a value calculation. Inclusion of other variables besides price, earnings and inflation can improve fit.

For more background, see:

Category: Markets

Comments

8 Responses to “The market is cheap! No! It’s expensive!”

  1. Deborah on September 21st, 2007 4:45 pm

    Hi Richard,

    I think this would go towards my overall negative view of where the market is heading as I suggested in my last comment a few posts back.

    I think a squeeze on consumer spending is coming and that will hurt business and their profit margins and their growth, which could become negative or flat and that just messes with all the analytical tools being used. They fall apart and people see that risking their money for P/E in the range of what they could get in a guaranteed deposit is fool hardy. Some are less than what you could get with out risking losing your capital.

    Certainly I’d probably be wanting to look at companies that would have business in emerging economies as they don’t have so much “stuff” already and would have more demand as incomes increase. I’d also be looking to ensure there isn’t a lot of government debt and crazy social programs. I think you want to see strong support for education, but government that leaves people to be responsible for their lives and doesn’t pretend to be an omnipotent magic box of endless resources that magically appear. There is no midas and people seem to think that it exists through government.

  2. Richard Beddard on September 21st, 2007 5:04 pm

    Hi Deborah, great to hear from you again. I’m going to update Fisher’s analysis next week. It still indicates the bull market has further to go. It won’t last forever, though. Nothing ever does.

    That’s a pretty good recipe for economic development you’ve got there :-)

  3. Robin Soole on September 24th, 2007 1:40 pm

    After reading Ken Fisher’s book ‘The Only Three Questions That Count’ I think he makes a persuasive argument that PE is no indicator of stock market returns (i.e. there is very little correlation).

    In fact, even if we go into recession this will not indicate that the market is going to perform badly, and if we are not in recession then this is no indicator that the market will perform well.

    Therefore I am keeping an open mind and continuing to stay fully invested in equities. I will be interested to see Ken Fishers next earnings yield report. Can we access this online somewhere?

    Many thanks

  4. Richard Beddard on September 24th, 2007 2:29 pm

    Hi Robin,

    Interesting you should remind me of Ken’s book and his debunking of the PE. I’ll have to go back and look at what he said.

    There’s plenty of evidence for a value premium too (probably using the pe ratio).

    The interesting thing is the earnings yield is the inverse of the pe ratio, half of the earnings yield/bond yield spread he advocates and we’ve followed. So in tandem with the bond yields he thinks it is significant.

    I have the earnings/bond yield spread from Fisher Investments (as of 13/9) and will publish a blog on it later today. But since you ask, the spread is 3.2%. In other words, it’s widened.

  5. Robin Soole on September 24th, 2007 3:57 pm

    Thanks Richard.

    I am surprised the gap widened before the rate cut. No doubt you will offers some thoughts on this in your next post :-)

    As a momentum investor I do not much care about either growth or value. In other words, I am really only concerned with what other people have recognised as a potentially good investment and I am following them. Right now China and the emerging economies have momentum.

    I do not know why this is, but in the case of China I would hazard a guess that

    (a) China is hosting the Olympic games next year and is probably ploughing all those surplus American dollars into infrastructure projects
    (b) The Chinese retail investors will soon be able to invest outside of their country. This will bring a lot of inexperienced investors into the market with a lot of savings by all accounts. This will probably push share prices up in the emerging economies.

    Of course, anything can happen but I would say the probabilities of good global performance are higher than bad right for now.

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