I thought if long-term performance was as closely tied to "earnings power" as I thought it ought to be, then fifteen years of past earnings data and fifteen years of future share price growth should be enough to detect this relationship…I gave no thought to the possibility that any normalized P/E effect would be discernible over much shorter time periods.
Well, I should have given that possibility some serious thought, because the normalized P/E effect is discernible over much shorter periods of time.
In fact, the normalized P/E effect is discernible in a way I did not expect to find – and may even have subconsciously preferred not to find.
I write about long-term investing on this blog, because I think about long-term investing and I want others to think about it too. As a result, I really don't want to present findings from my little normalized P/E study that suggest there is a short-term P/E effect. More than anything, I really don't want to present findings that suggest the normalized P/E effect is ever more pronounced over a shorter period of time than a longer period of time.
That last sentence requires some explanation. I will need to (reluctantly) employ a physics analogy. I say "reluctantly," because I've (not so subtly) hinted that economists (and their science) suffer from a certain degree of physics envy, as well as an unhealthy attachment to precisely quantifiable figures. Nevertheless, I think this physics analogy will work, because everyone knows enough physics to know what I'm talking about.
The Weighing Force
Conceptually, I thought of the normalized P/E effect as evidence of a perpetual, pervasive, propensity that I'll call "the weighing force" (for Ben Graham). Knowing what we know about markets, their participants, and the aims of those participants, we should expect markets to often appear efficient, simply because there is a natural tendency for price and value to converge.
I use the term "natural" quite loosely here, because we're dealing with a complex, human phenomenon. Still, it seems appropriate to consider this tendency for price and value to converge to be a natural consequence of value-seeking market participants.
This is especially true, because some market participants are capable of extracting value outside the market by purchasing stock to gain influence or complete control of a business and then milking that business for cash, selling corporate assets, or integrating the entire business into their own operations.
For evidence of this "outside" influence on the stock market, consider Marty Whitman's Third Avenue Value Fund, which makes purchases with the expectation that value will be extracted from many of the fund's holdings without the fund actually selling shares in the open market.
Simply put, if you create a market for productive assets (like pieces of businesses) the weighing force is natural and unavoidable, because not every market participant is forced to "play the market" on both sides of the transaction.
Whether most participants do or not isn't the point. The mere presence of some participants that can individually or jointly extract value from stocks without selling in the market is crucial to the kind of market formed. To the extent that value can be extracted outside a public market, that market becomes less like a casino or racetrack and more like a highly liquid form of the private (negotiated) market for similar assets.
The Physics Analogy
I thought of this "weighing force" as being a bit like gravity, in that it would appear to be a weak force (much weaker than other market forces) over short time periods (just as gravity appears weak over short distances), but be a pervasive force (acting on all things at all times) that would assert itself quite clearly over long time periods – while other seemingly stronger forces would fail to have a discernable effect over long time periods.
As a result, I expected to find the normalized P/E effect (as evidence of this weighing force) is extremely obscure (or even non-existent) over the short-term and extremely obvious over the long-term (because other market forces have little durable effect at such range).
Is that what I found?
No – not exactly. The normalized P/E effect is indeed quite conspicuous over long periods of time. However, the normalized P/E effect is much more pronounced over the short-term than I expected it to be. There's also another problem, which is the whole point of this post.
After my post "A Look At Normalized P/E Ratios and the Election Cycle" provided evidence of a one-year normalized P/E effect within that small set of years, I began to look into the normalized P/E effect over time. To give you an idea of the magnitude of the effect over time, here is the compound annual point growth in the Dow for the low normalized P/E half and the high normalized P/E half of our group over various time periods.
Low Normalized P/E Half: 8.59%
High Normalized P/E Half: 6.25%
Low Normalized P/E Half: 7.13%
High Normalized P/E Half: 6.24%
Low Normalized P/E Half: 7.21%
High Normalized P/E Half: 6.43%
Low Normalized P/E Half: 8.48%
High Normalized P/E Half: 6.11%
Low Normalized P/E Half: 9.32%
High Normalized P/E Half: 4.89%
As you can see, the normalized P/E effect over one year is about as great as the normalized P/E effect over ten years and much greater than the normalized P/E effect over both three years and five years. This is troubling.
Obviously, I can try to come up with a logical explanation to support the data, but I'd rather not. When logic and the data both point to the same conclusion we have something that might prove useful. When logic and the data do not point to the same conclusion, we may have an interesting and unexpected finding – but, whatever we do have does not rise to the level of actionable intelligence.
Therefore, I must once again caution against acting on some data I present in one of my posts, unless you have a very good reason for doing so. For now, I don't believe there is a very good reason for believing a short-term bet on a rise in the Dow placed when the Dow has a below-average normalized P/E is a sound bet – and I certainly have no reason to believe a one year bet will work better than a three or five year bet, despite the fact that history suggests this may be the case.
Just to make sure you know there aren't any new ideas in this post, I close with my favorite quote from Ben Graham:
…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.
I'm sure I'll be revisiting this topic some time in the future – after all, I still need to explain how I calculated these normalized P/E ratios. That will be the subject of my next post.