Wednesday, 22 August 2007

The Fallacy of Forward P/E's

A common argument doing the rounds is that stock markets are not over-valued because the forward P/E ratio, that is a P/E ratio based on 1 year out forecast earnings is historically inexpensive.

One objection I have to this much used measure is that forecast earnings can change very quickly. There have basically been no downgrades to the major US brokers and investment banks however you can rest assured over the next few months there will be some major revisions.

John Hussman of Hussman Funds has an excellent article dispelling amongst other things the claim that forward P/E multiples show that the market is currently historically inexpensive.

The article is quite long and starts off with a look at another fallacy - that the earnings yield of the S&P 500 (based on forward operating earnings) should be equal to the 10-year Treasury bond yield.

Hussman dismisses this as a:

statistical artifact of the period from 1982 to the late 1990's, during which U.S. stocks moved from profound undervaluation (high earnings yields) to extreme overvaluation (depressed earnings yields).

The implication is that there is a one to one relationship between earnings yields and interest rates. Hussman adds that:
Unfortunately, there is nothing even close to a one-to-one relationship between earnings yields and interest rates in long-term historical data. Why doesn't Wall Street know this? Because data on forward operating earnings estimates has only been compiled since the early 1980's. There is no long-term historical data, and for this reason, the “normal” level of forward operating P/E ratios, as well as the long-term validity of the Fed Model, has remained untested.

Then with some maths I don't follow completely he comes up with the following graph that illustrates that the relationship between earnings yields and Treasury yields do not move in unison except for the period from about 1980 to 1998 , which is the entire basis of the model.

Moving on to the issue of P/E ratios based on forward operating earnings. It is generally accepted that the historical average P/E of the market is between 14 - 16 times. However that average relates to trailing earnings not forward earnings. Hussman points out that the average historical P/E based on forward earnings is more like 12 times. The S&P500 is currently at about 16 times. In addition:
that average of 12 includes the heights of the late 1990's bubble. The historical average was just 10.6 prior to that point.

Hussman also touches on another interesting point regarding profit margins:
It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

That assumption is hard to support. Historically, profit margins have been highly cyclical. But it's important to understand the argument here. I am not arguing that stocks are vulnerable because profit margins are going to come down, so earnings are going to come down, so stocks are going to follow earnings lower. No. There is virtually no correlation between year-over-year movements in earnings and year-over-year movements in stock prices. The argument isn't about the near term direction of earnings.

Rather, the argument is about the long-term valuation of stocks. If an investor is going to use the current level of earnings to determine the reasonable price to pay for a long-term asset, it had better be true that those earnings represent a normal and sustainable level of profit. You wouldn't buy a lemonade stand by extrapolating the profits it earns in August.

Those are some pretty important points in bold which basically boil down to the conclusion that stocks are not cheap or even reasonably priced in historical terms. Hussman sums up the situation succinctly:

Investors appear eager to “scoop up” so-called “bargains” on the belief that stocks are “cheap relative to bonds.” All of this is predicated on the belief that profit margins will remain at record highs, that the Fed Model is correct, and that P/E ratios based on extremely elevated measures of earnings should be evaluated based on norms for much more restrained measures of earnings.

That's not investing. It's speculation. And it's speculation that runs entirely counter to historical evidence. While an improvement in market internals might provide reason to speculate modestly on the basis of market action, there is no investment merit in current market valuations. Again, we do not need stocks to become “fairly valued” or undervalued in order to remove most or all of our hedges, but in the absence of reasonable valuation, we do need constructive market internals (short of extremely overbought or overbullish conditions).

Look at the composition of S&P 500 earnings. Financials currently make up about 25% of the S&P 500 market capitalization, but close to 40% of the earnings. Wages and salaries as a fraction of U.S. corporate profits have rarely been lower. Irresponsible lending and suppressed labor costs have been strong contributors to S&P 500 earnings in recent years thanks to a massive leveraging cycle – financial profits exploded, while wage demands stayed low because it was easy to spend out of home equity withdrawals and strong real-estate gains. But these are not permanent factors, and it is dangerous to value stocks as if recent profit margins will endure in perpetuity.

This brings me back to the beginning of the post where I pointed out that the market is yet to factor in earnings downgrades for the majority of the financial sector.

Also some commentators currently assume that after a few months of turmoil in credit markets, a few rate cuts by the fed will get things back to normal. That is the normality of the last 6 years of easy credit, massive fees and big profit margins for financials.

However along the lines of what Hussman is saying I believe that there is a strong case for a reversion to normalcy more in line with historical norms of the last 60 years. Obviously this would not be a positive environment for stocks given current market conditions.