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This Rally May Need a New Source of Fuel

Recs

22

June 16, 2009 – Comments (13)

This weekend's NYT had a great article on just how expensive the market is after its recent massive rally. 

Take a look at the market's P/E ratio.  Since 1938, the S&P 500 has traded at an average multiple of 12.6 its trailing earnings.  After its recent run, the S&P 500 now sits at over 100 times its trailing GAAP earnings.

If you believe that we are in extraordinary times where companies will experience expenses that they would not normally incur, you could look at operating earnings, but I personally hate giving companies a free pass to exclude whatever "one-time" charges they want.  The S&P 500 is currently trading at 22 times operating earnings, which is still higher than the average of 19 times that we have seen for the past twenty years.  In fact, I personally would argue that the market has been trading at an unreasonably high multiple over the past two decades because growth was fueled by leverage and a number of unsustainable bubbles like housing.  Growth going forward will likely be more muted than it was over the past twenty years and as a result, the market's earnings multiple should be lower.

Many argue that the market always trades at a premium to trailing earnings at the end of a recession (if you even believe that is where we are in the economic cycle).  According to a study by Ned Davis Research that is indeed the case.  Looking at the average valuation of stocks after bear markets since 1929, the company found that for the first three months after the bear market ends the market's P/E ratio tends to climb by 10%.  During the recent rally, the earnings ratio of the S&P 500 has soared by almost 40%!

Given the depth of the current recession, one might be able to justify the market's current valuation if we are headed for a rapid "V" shaped recovery.  Unfortunately, I do not think that the economy will rebound that quickly.

This Rally May Need a New Source of Fuel

Deej

13 Comments – Post Your Own

#1) On June 16, 2009 at 8:56 AM, dickseacup (67.75) wrote:

Rec given. The phrase "irrational exuberance" springs to mind.

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#2) On June 16, 2009 at 9:42 AM, portefeuille (99.44) wrote:

This P/E discussion never ends, does it? Have a look at this post (and for P/B at comment #8 here).

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#3) On June 16, 2009 at 9:50 AM, portefeuille (99.44) wrote:

I almost wish the P/E was negative for a year or so. That might put it to rest. Maybe. (still talking about the discussion)

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#4) On June 16, 2009 at 11:08 AM, Alex1963 (28.89) wrote:

Deej

I found this article very interesting on this topic. I'd be curious what your thoughts might be. And anyone else who cares to comment. I hope we can avoid nitpicking over the inflation figures used. Can we all just assume for arguments sake that the sources for those figures and the rates cited are acceptable for this exercise? 

S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS

 

There is a great debate among investors and academics about “trough” PE multiples, i.e. what is the appropriate multiple to apply to S&P 500 earnings at market trough. There is clearly a need for thorough objective analysis. The following charts and observations, going back to 1927, should help in this debate.

CONCLUSIONS

Using historical absolute PE lows to assess the potential downside to the S&P 500 Index is simplistic and based on superficial, non-rigorous analysis. The absolute historical lows used by the bears, while strictly accurate, were attained in high inflation periods, not comparable to the present.Using the Rule of 20 to assess PE multiples takes into account the inflation environment and is thus a better tool to value equities in general.Using this method, and assuming inflation rates in the 0-2% range, trough PE multiples should be 12-14 times trailing earnings.The current financial crisis is substantially distorting S&P 500 earnings, both reported and operating, in an unprecedented way. Using trailing earnings, reported and operating, can result in a meaningful underestimation of Index earnings in the present environment.Macro earnings estimates are more appropriate in the current exceptional circumstances. Goldman Sachs’ $63 estimate for 2009 appears conservative in light of historical evidence. A low probability worst case scenario would take earnings down to the $43 level.Trough valuation analysis shows trough S&P 500 Index levels at 720 using 2009 estimates (which are lower than trailing), with a low probability downside risk to between 516 and 602 

http://www.news-to-use.com/2009/03/s-500-index-pe-at-troughs-detailed-80.html 

Alex 

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#5) On June 16, 2009 at 11:18 AM, portefeuille (99.44) wrote:

#4 In the graph "S&P 500 profits and index troughs" of the article you linked to you can see the famous anomaly of 2002. One of the rare cases of "the market" falling after profits have "bottomed".

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#6) On June 16, 2009 at 11:20 AM, Alex1963 (28.89) wrote:

Port

The article above does cite the same Siegel article that I believe you debunked convincingly. But there are still good points here IMO 

Curious about your thoughts too

Alex 

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#7) On June 16, 2009 at 11:29 AM, bigpeach (31.57) wrote:

I'd like to smack the person who first calculated the P/E of an index and pretended it was useful. It simply doesn't work well as a valuation metric. The market may need another source of fuel to continue rising, but the P/E of the S&P 500 isn't a supporting reason.

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#8) On June 16, 2009 at 11:46 AM, portefeuille (99.44) wrote:

I'd like to smack the person who first calculated the P/E of an index and pretended it was useful. It simply doesn't work well as a valuation metric. The market may need another source of fuel to continue rising, but the P/E of the S&P 500 isn't a supporting reason.

very, very, true!

And when siegel gets involved (see comment #5 here) we pass the border to comedy-land.

I join in the metaphorical beating. Can we beat the ones who created the dow jones index (and "maintain" it in the 21st century) as well?

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#9) On June 16, 2009 at 11:49 AM, portefeuille (99.44) wrote:

16 recommendations, I guess the P/E fetish is still very much alive ...

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#10) On June 16, 2009 at 11:57 AM, masterN17 (< 20) wrote:

P/E is so cooked these days with options etc.  It is a weak metric and absolutely absurd to use it as the only metric for evaluating market health and stock prospects.

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#11) On June 16, 2009 at 1:12 PM, JakilaTheHun (99.94) wrote:

I think trying to value the market by P/E ratios is a terribly flawed method of valuation.  Given the sharp plunge in earnings over the past year, one would be left to conclude that the market should trade at some absurdly low level.

I frequently encounter this same problem with individual stocks.  A company might have $10 of net assets per share (under GAAP accounting, which often undervalues assets), had earnings of $1 per share for FY '06 and '07, but then had earnings of 10 cents per share for FY '08. 

Does that mean the stock is worth $1.50?  If you believe in the power of P/E ratios, it does.  Realistically speaking, however, the company is probably worth at least $13, even assuming its earnings power is severely limited going forward. 

That's the other problem here.  Most companies "earnings" are lower than they will be in the future.  This isn't because everything will be rosy in the near-term future.  It's because "earnings" were largely suppressed by issues such as oversupply and it takes time for firms to cut their expenses down after a boom stage.  Once they cut the fat, earnings will increase again. 

So basically, the trailing P/E takes into account very few real-world factors in trying to value individual companies and the market in general.  It really only works with certain cash-cow firms that have very consistent earnings with some level of diversification in their product lines. 

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#12) On June 16, 2009 at 1:32 PM, bigpeach (31.57) wrote:

Yes, I agree, P/E does have its flaws. It makes a company look expensive during bust times and cheap during boom times. Generally however, I don't have a problem with looking at P/E as one part of a valuation analysis for a single company. The point portefeuille and I have been making on this site is that applying the same thinking to an index doesn't work. A lot of people seem to be trying to do that these days even though the math doesn't work thanks to limited liability.

Frankly I don't understand why everyone wants to try to value "the market." Short of individually valuing every company and summing, I don't know how you would even do such a thing.

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#13) On June 16, 2009 at 3:38 PM, portefeuille (99.44) wrote:

morgan stanley on this "market P/E"

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