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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 over valued.

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 over priced. 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.

Lesson for today's market: P/E ratios "seem a little high" but we don't have to worry as forward P/E ratios are very reasonable ... just try to ignore the above chart that shows we are currently at or near an earnings peak. This time will be different.

Sarcasm aside, I don't know the future, but it would seem prudent to have some "dry powder" on hand ... just in case.

Bear Markets are Bad

I have noticed that we are in a secular bear market right now and after 12 years everybody is getting a little cranky about the whole thing - I just can't figure out why.

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. I hope we stay in a secular bear market for a long time and I get to spend all my adult life buying stocks at depressed prices.

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.

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 (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 then 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.

Lesson for today's market: The key to successful investing is buying good companies at good prices. Do not pay a large premium for a "hot" stock.

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. A dismal science, indeed.

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.

Lesson for today's Market: Compares to historical CAPE values, the S&P 500 may be significantly overvalued.

Bonds Make Stocks Cheap

In a rather embarrassing blunder, the first "myth" I wrote about got published as a stand-alone article. Please read it here.

Lesson for today's Market: Cash is King.

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.

When researching this topic, I found an old article by Mr. Kostohryz that explains the situation nicely and I have no interest in re-inventing the wheel. Mr. Kostohryz is a very successful contributor here on Seeking Alpha so please take a moment to read his fine work here.

Lesson for today's market: Over the last several years, either the bond market or the stock market has been seriously perverted. With current central bank "easing," I believe it is the bond market that is distorted. That is just my personal opinion, I could be wrong.

Gold Protects Against Inflation

I almost didn't include this section, just to save myself the hassle of deleting all of the inevitable hate mail...but what the heck: gold serving as inflation protection is a myth. It is an extremely prevalent myth, no doubt, but still a myth.

I decided to actually use my statistics training for once and took the monthly gold prices and CPI reading for the last 30 years (one bull, one bear market) in order to analyze the data for a correlation. For the first half of this period, the correlation between gold and CPI was actually negative. Since 2000, however, there was a very weak correlation -- the highest monthly correlation stayed below 20%. Overall, this correlation was considered not to be statistically significant.

Taking a large step back, if one looks at the commodity and stock market (real) prices over the last two centuries, it is very apparent that there a cyclical trend. Stocks go into a bear market as commodity prices increase in real terms. Every 16-18 years or so, this cycle reverses, as stocks go into a bull market and commodities decline in real prices. This fits a more empirical look, above, of gold and CPI prices over the last 30 years. During the stock bull market, gold prices went down and during the ensuing stock bear market, gold prices increased. Inflation had nothing to do with it.

When viewed this way, the Great Secular Bear and the explosion of gold prices since 2000 does not appear to be the end of the world, or scary or even that interesting. Rather it appears to be one more mundane repetition of a cycle that has repeated itself for at least the last two centuries.

You may send your hate mail now.

Lesson for today's Market: As we are currently only about two thirds of the way through a secular bear market, having exposure to gold or other commodities seems prudent.

Source: 7 Investing Myths And What Investors Should Do About Them