Regression To The Mean

Includes: DIA, SPY
by: Thomas Barnard


The average (mean) P/E ratio for the S&P 500 for the past 132 years is 16.64.

The P/E now is 26, which is high.

Oil is declining, stocks are declining, pay attention.

Shiller's S&P 500 P/E

Shiller maintains records of the S&P 500 going back beyond 100 years. In that time the average P/E (Stock Price/Earnings per share) has been 16 to 17, more or less. The P/E at the time of Shiller's last computation was 26.45. In 1929 just before The Crash, the P/E ratio was 30.

And as I noted in a previous piece from 1930 to 1995, a 65 year period, the P/E never got above 24.

There is no way that the present P/E ratio can be viewed as less than high.

What is regression to the mean?

Mean here is defined as the average. The average P/E from 1881 to 2015 is 16.64. This is some 132 years, more or less. Depending on the range of years you draw your sample, the P/E ratio can be higher or lower. The last 20 years, the mean P/E ratio has been 19.03. These included the end of the Clinton term, when things were very heady, and the P/E hit its all time high of 44.20.

In a previous article I showed that for the 65 years from 1930 to 1995, the highest the P/E ratio ever got was 24.

For the 1980's, the mean P/E was 11.34. Quite a bit lower than the long term average, and much lower than today's average.

If we take the long term view, and multiplied earnings by 16.64, we get an S&P 500 number of 1316, which is sobering with a Friday final of 1971. Regression to the mean would represent a decline of another 33%.

We Know Why the Market is Overpriced

The reason is straightforward. Bernanke decided he needed to take an additional step to move the economy beyond lowering the rediscount rate and other methods at his disposal. In medical terminology he performed an intervention. That procedure was to buy mortgage bonds, what was called Quantitative Easing (QE). QE1 was followed by QE2, and QE3. I stated in a previous piece that Bernanke owns this bubble.

We will see over time if interfering with normal market pricing of risk (that is, interest rates) helped the economy. Certainly, it prevented investors from finding a reasonable rate of return, and has been a disaster for seniors.

The mechanics of the bubble are quite simple. When the bondholders got paid off, they had a mountain of cash to invest, and no means to get a reasonable return on their money. A portion of that money went into the stock market, and that pushed prices higher.

The economy's low growth, low inflation, slow labor growth is a nearly magic formula for the stock market, a Goldilocks economy, and it responded with a bubble. Big surprise.

To be sure, labor growth has not resulted in any push-pull inflation, and that is because the government statistics cannot be relied on. The government says unemployment is around 5%, but if you compute labor stats on the same basis they were in the decades before 1994 as ShadowStats does, then you are looking at unemployment of more like 22%. Look here.

As an opinion, I think it would have been much happier if Congress had decided to dramatically spend on infrastructure. Politicians could look on it as an investment in the economy. Bernanke was faced with a Congress unwilling to take such steps, so he went out on his own. Personally, I think QE1 was okay to do on his own, but I think I would have passed on the subsequent quantitative easings, which have put the stock market, and perhaps the economy, at risk.

China's Stock Market has Crashed

China saw a 30% decline. We would be inclined to call that a crash if their market had not gone up 150% in the year and a half prior. But it's a decline to be monitored. Is it over? One needs to recall that it took the U.S. from October 1929 to June 1933 to reach its final decline. We will see.

China also has a property market that is overpriced as Chanos has pointed out. We will see if a managed economy can right itself promptly.

Some Commodities Are Under Pressure

Oil is the most prominent of the commodities under pressure. It has gone from $100 a year ago, down to $40. This is a 60% hair cut. Gold has declined. Copper has declined. Silver, platinum, all in decline. These declines can be traced to a decline in demand, and increases in supply. It will take a while for equilibrium to re-establish itself. Some rigs are being idled, and we may have to wait for economies to increase their activity.

Intelligent Investors Are Waiting

Former Pimco CEO, Mohamed El-Erian has moved to cash, and less liquid investments. Buffett takes market risk out of his portfolio when he buys an entire company (as opposed to only buying some smaller part, and putting that in his portfolio), like he did recently with the Precision Castparts purchase.

Jeremy Grantham reduced stakes in 250 companies, and reduced his exposure to Apple by one-third. Gratham got burned when he called a market top when the S&P 500 went above 30, which was the point the market hit just before the crash in 1929. Many customers fled, and the P/E went to historic heights of 44.

What to Watch

It still feels a little early to commit, but oil stocks have followed down the price of oil, but a little less dramatically. Iranian oil coming on stream may knock oil prices on their ass. At some point, not yet, there may be a once in a decade, or possibly even a once in a lifetime buying opportunity. I would be inclined toward the dividend paying majors, Exxon (NYSE:XOM), Royal Dutch (NYSE:RDS.A), Chevron (NYSE:CVX).

Oil prices will not stay low forever, but they could remain low for a while.

Coal is intriguing. And Soros tiny investment in Peabody (NYSE:BTU) and Arch Coal (NYSE:ACI) is a tip off. I bought a tiny amount of Peabody myself. The huge supply of natural gas does make this a chancy bet until the price of coal stabilizes.

Again, as an opinion, I think it is a reasonable goal to wean ourselves off of all fossil fuels. It's not going to happen over night. Coal will be around for at least one hundred years. Fossil fuels represent a one-time, perhaps one thousand year kindling for civilization. After it's gone, it's gone. Sucking ethanol from crops represents a possible food disaster, so it's hard to get behind that. Solar seems the most sensible. The sun will be around for billions of years, unlike fossil fuels. Wind turbines are okay. Nuclear power will prevent damage to the ozone, and plant designs with a lake on top of the nuclear furnace, represent a step forward in design. And of all the ecology concerns, ozone depletion seems to me the most troubling. If the ozone layer goes, we'll all be wearing space suits and living underground.

But putting things into perspective, the Sahara desert turns into a green place every 20,000 years because of changes to the planet's orbit and tilt, and then after another 20,000 years, the monsoons move back south, and the Sahara becomes a desert again. We cannot change the ecology to change that, some things are beyond our control.

Two million years ago, volcanoes closed the isthmus of Panama, and changed weather patterns, and we began to have ice ages every hundred thousand years or so. So, the planet was pretty warm before that. If the planet warms up, water levels could certainly rise and swamp coastal cities. We simply have to do what we do best as intelligent beings, cope with the changes. Adapt.

How Will This Play Out?

Europe's economy is in the doldrums and China will suffer an hiatus at the very least in its spectacular growth. The US may follow suit. With any luck it will be a mild recession.

Stock prices are another matter. If 16 is the P/E's average, that means that half the time it is below 16. So, the stock market could easily drop below the mean, in fact, by half. Bernanke pumped so much air into the balloon that that balloon could pop.

Would I take money out of the market now? It might be prudent to raise some cash, take it from your winners. Take it from stocks, companies, with poor management. If stocks do end up going down broadly, it will put you in a position to buy somewhere around the bottom.

The other way for the P/E to return to more normal numbers is if the earnings were to increase. This would be the happiest way for stocks to return to normal. But earnings growth is not forecast to rise very much near term.

If interest rates were to return to more normal rates, then stocks would fall as investors moved into safer rates of return. The Fed is likely to leave interest rates where they are for now. Because they have left interest rates so low, there is nothing in the cupboard for them to do if things go south again. To some extent, without tools, they have made themselves useless.

Certainly, stocks may bounce back after the big hit on Friday, but it seems likely there will be significant speed bumps to a higher stock market without a much stronger economy.

Disclosure: I am/we are long BTU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.