Pat sent me a note with this link from Yahoo Finance. Many articles lately attempt to justify equity prices, much like most experts were justifying staying out of stocks in 2009:
(…) Most experts agree that P/Es should be considered in the context of interest rates and/or inflation rates. Most experts would also acknowledge that P/E ratios, nevertheless, reveal little about how the market will move in the near-term.
“The forward P/E is a horrible indicator,” BMO’s Brian Belski said to Yahoo Finance.
Belski’s seen it all in his 27+ years on Wall Street, and he has shared some very smart observations about P/Es. In an October 2015 note to clients, Belski wrote (emphasis ours): “we have found that the average P/E at the end of prior bull markets has fluctuated rather significantly, averaging 18.4x but with a standard deviation of 5.4x. This suggests to us that valuation by itself is not reason enough for a bull market to end.”
Implied here is that a P/E of 17.0 says little, if anything, about downside risk. And even if “most experts agree that P/Es should be considered in the context of interest rates and/or inflation rates”, nobody really considers interest and/or inflation rates when discussing multiples.
Let’s do it, let’s consider inflation, pretending we are experts who “agree that P/Es should be considered in the context of interest rates and/or inflation rates”: the Rule of 20 stipulates that fair P/E is 20 minus inflation. It follows that the Rule of 20 P/E equals the actual P/E on trailing EPS plus core inflation. Here’s the Rule of 20 P/E at the same dates:
To paraphrase the BMO expert: ““we have found that the average P/E at the end of prior bull markets has fluctuated rather insignificantly, averaging 22.0 but with a standard deviation of 3.5x. Excluding the two outlier years, the average is 21.7x with a standard deviation of 1.5x. This suggests to us that valuation by itself is reason enough for a bull market to end.”
In reality, nobody really knows. What we do know is that as valuations get richer and richer, the odds are growing against equity investors, not only the odds of losing money, but also the odds of losing significant money. As a reminder:
Remember that the returns plotted above are averages with significant dispersions, especially in down markets. For example, the 6-m returns between 22.0 and 24.9 is +0.3% but the high is +29.4% and the low – 42.7%. And the higher you go, the steeper the next step…
By the way, you should also know that rising EPS do not immunize you when P/Es are high: in 7 of the 10 years considered here, profits were rising right into the equity peak.
You should also know that in 9 of the peak periods, inflation was rising.
How lucky do you feel? How unlucky can you afford to be?
2 thoughts on “High P/Es reveal nothing about the near-term moves. Hmmm…”
Denis, can I ask you a question about an older post? I’m not understanding a couple of your charts. Your probability of losses vs Rule of 20 chart, for example. There is no indicator on what the numbers across the bottom mean. Am I really reading this to say that there is a 60% probability of 25% losses within 12 months? The chart seems backwards to me. I would think there would be a higher probability of a small loss, and a lower probability of a larger loss. And the following 2 charts? I have no idea what you are trying to say.
Thanks.
Sorry for the confusion Richard. The horizontal axis is The Rule of 20 P/E. So history says that when the Rule of 20 P/E is between 22 and 24.9, like presently (22.6), 30-40% of the time equities declined in the subsequent 6-12 months. Note that the probabilities of losses would be higher if not for the prolonged internet bubble (which also impacts the returns tables below). Excluding that special period,the probabilities of losing money are in the 40-50% range. I hope this helps clarify the charts.
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