1. P/E Ratios are Useful Metrics
I am going to briefly express my opinion that the vaunted P/E ratio, the most cited valuation metric by far, is a deeply flawed metric. This particular metric comes in three flavors - current, forward and trailing, and each has their own problems. Yet many investors, analysts and authors routinely trot them out to prove their case that the market is undervalued or overvalued.
Let us take a look at a few quick examples. Even though valuations seemed a little high back in 2007, most investors were told not to worry because the forward P/E for the Dow Jones was actually quite low. Of course, what followed was a massive bear market that was not predicted by either forward or current P/E ratios.
Moving forward to 2009, at the March low, the current P/E was at 144 - suggesting stocks were ridiculously overpriced. Even the supposedly superior CAPE trailing P/E had the stock market as 25% over valued at that time. These numbers seem outrageous only in hindsight; at the time, using these metrics as proof, many serious analysts and economists were arguing passionately that the stock market was extremely overvalued at the March low.
The problem here is actually quite obvious: corporate profits are highly cyclical and none of the P/E ratios captures that information. The P/E ratio always values the market "wrong" as it doesn't count for the cyclical nature of earnings. However, this divergence becomes greater as the earnings cycle reaches a peak or trough. If earnings are at a peak (2007) then the P/E ratio will greatly overvalue the market while at a trough (2009) the same metric will greatly undervalue the market.
The below chart, courtesy of the St. Louis Fed, plots the ratio of corporate profits to Gross Domestic Profit over time. Not exactly what we are talking about here but it does underscore how very cyclical profits are.
2. Bear Markets are Bad
Remember back to all of those wonderful buying opportunities since 2000 where the market dipped well below its decade long average price? Any investor who bought the dips, or even simply dollar cost averaged out their purchases, has had the opportunity to buy high quality stocks at very reasonable prices.
Now, my sincerest sympathies are with my investing friends who are at or near retirement, but the rest of us are in the accumulating stage. Why would we cheer if prices go up and stocks become more expensive to accumulate? When prices are low we are buying more earnings, more dividends, for each dollar we spend. This is a very good thing for an investor.
Lesson for today's market: For a long-term investor saving for retirement, all that matters is the life-time of wealth accumulated from stocks - what path they took along that journey is completely irrelevant. Stick to your investing plan, relax, and enjoy life.
3. Stock Valuations are Naturally Higher when Interest Rates are Low
This is a commonly accepted truth; however, this simply is not true. In reality, economists think stock valuations should be higher when interest rates are low. In a quick aside, I wonder why economics is the one branch where experts get away with stating their theories as facts, despite obvious empirical evidence to the contrary.
Taking a look at Robert Shiller's CAPE ratio - we find that the average value over this century was 16.4. However, when we look only at the years when average interest rates were below 3%, the average ratio actually drops to 13.6. There is very considerable variation in the relationship between P/E ratios and interest rates, if there is one at all, but there is no evidence that the ratios expand when interest rates are low.
4. The Equity Premium
Like the belief that P/E ratios are higher when interest rates are low, it is commonly believed that stocks will trade at prices that give them a higher earnings yield as compared to a bond's yield. This is called the equity premium and it makes complete sense: to compensate for equity risk an investor should insist on a higher earnings yield. Unfortunately, it is not true, or at least hasn't been up until recently. For the capital markets to "work," stocks should produce higher returns than bonds. Otherwise, stockholders would not be paid for the additional risk they take for being lower down in the capital structure. As you can see in the table below the relevant investment span should be long enough that equity investors will be rewarded for bearing risk, right? Not always! As displayed in Table 1, trailing returns for stocks have not come close to the excess returns over bonds that we have all come to expect, even after stocks worldwide doubled from the lows reached during the global financial crisis that began in early March 2009. They have not come close in the United States, in the rest of the developed world, and most assuredly not in the emerging markets.
5. Great Stocks are Worth a Premium Valuation
Yet another investing myth that is all too common as I regularly see comments from individuals on Seeking Alpha justifying their favorite stock's high valuation. As an example let's take a look at Wal-Mart (NYSE:WMT).
At the turn of the century, Wal-Mart was selling at a P/E of over 44. This seemingly very high valuation was defended endlessly by the retail investor and the chattering classes alike who spoke elegantly about Wal-Mart's amazing growth story. A story that turned out to be true, actually, as the company grew revenues and earnings at a much faster rate than the general market.
Not that this helped any investor who actually bought the stock back in 2000 as the price was flat over the next decade. Because of the very high starting point, earnings growth didn't translate into higher prices as essentially it took an entire decade for the stock's earnings to catch up to that initial generous valuation. Many investors overlook the unpleasant beast that is P/E compression. Please don't, it can be a dangerous thing and should be respected.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.