P/E Ratio Close to 27. That's Higher Than at Any Other Point in the Last 130 Years, Save the Twenties and the Nineties.
Lisa Lisa
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August 15, 2007
Economic Scene
Remembering a Classic Investing Theory
By DAVID LEONHARDT
More than 70 years ago, two Columbia professors named Benjamin Graham
and David L. Dodd came up with a simple investing idea that remains
more influential than perhaps any other. In the wake of the stock
market crash in 1929, they urged investors to focus on hard facts -
like a company's past earnings and the value of its assets - rather
than trying to guess what the future would bring. A company with
strong profits and a relatively low stock price was probably
undervalued, they said.
Their classic 1934 textbook, "Security Analysis," became the bible for
what is now known as value investing. Warren E. Buffett took Mr.
Graham's course at Columbia Business School in the 1950s and, after
working briefly for Mr. Graham's investment firm, set out on his own
to put the theories into practice. Mr. Buffett's billions are just one
part of the professors' giant legacy.
Yet somehow, one of their big ideas about how to analyze stock prices
has been almost entirely forgotten. The idea essentially reminds
investors to focus on long-term trends and not to get caught up in the
moment. Unfortunately, when you apply it to today's stock market, you
get even more nervous about what's going on.
Most Wall Street analysts, of course, say there is nothing to be
worried about, at least not beyond the mortgage market. In an effort
to calm investors after the recent volatility, analysts have been
arguing that stocks are not very expensive right now. The basis for
this argument is the standard measure of the market: the price-to-
earnings ratio.
It sounds like just the sort of thing the professors would have loved.
In its most common form, the ratio is equal to a company's stock price
divided by its earnings per share over the last 12 months. You can
skip the math, though, and simply remember that a P/E ratio tells you
how much a stock costs relative to a company's performance. The higher
the ratio, the more expensive the stock is - and the stronger the
argument that it won't do very well going forward.
Right now, the stocks in the Standard & Poor's 500-stock index have an
average P/E ratio of about 16.5, which by historical standards is
quite normal. Since World War II, the average P/E ratio has been 16.1.
During the bubbles of the 1920s and the 1990s, on the other hand, the
ratio shot above 40. The core of Wall Street's reassuring message,
then, is that even if the mortgage mess leads to a full-blown credit
squeeze, the damage will not last long because stocks don't have far
to fall.
To Mr. Graham and Mr. Dodd, the P/E ratio was indeed a crucial
measure, but they would have had a problem with the way that the
number is calculated today. Besides advising investors to focus on the
past, the two men also cautioned against putting too much emphasis on
the recent past. They realized that a few months, or even a year, of
financial information could be deeply misleading. It could say more
about what the economy happened to be doing at any one moment than
about a company's long-term prospects.
So they argued that P/E ratios should not be based on only one year's
worth of earnings. It is much better, they wrote in "Security
Analysis," to look at profits for "not less than five years,
preferably seven or ten years."
This advice has been largely lost to history. For one thing,
collecting a decade's worth of earnings data can be time consuming. It
also seems a little strange to look so far into the past when your
goal is to predict future returns.
But at least two economists have remembered the advice. For years,
John Y. Campbell and Robert J. Shiller have been calculating long-term
P/E ratios. When they were invited to a make a presentation to Alan
Greenspan in 1996, they used the statistic to argue that stocks were
badly overvalued. A few days later, Mr. Greenspan touched off a brief
worldwide sell-off by wondering aloud whether "irrational exuberance"
was infecting the markets. In 2000, not long before the market began
its real swoon, Mr. Shiller published a book that used Mr. Greenspan's
phrase as its title.
Today, the Graham-Dodd approach produces a very different picture from
the one that Wall Street has been offering. Based on average profits
over the last 10 years, the P/E ratio has been hovering around 27
recently. That's higher than it has been at any other point over the
last 130 years, save the great bubbles of the 1920s and the 1990s. The
stock run-up of the 1990s was so big, in other words, that the market
may still not have fully worked it off.
Now, this one statistic does not mean that a bear market is
inevitable. But it does offer a good framework for thinking about
stocks.
Over the last few years, corporate profits have soared. Economies
around the world have been growing, new technologies have made
companies more efficient and for a variety of reasons - globalization
and automation chief among them - workers have not been able to demand
big pay increases. In just three years, from 2003 to 2006, inflation-
adjusted corporate profits jumped more than 30 percent, according to
the Commerce Department. This profit boom has allowed standard, one-
year P/E ratios to remain fairly low.
Going forward, one possibility is that the boom will continue. In this
case, the Graham-Dodd P/E ratio doesn't really matter. It is capturing
a reality that no longer exists, and stocks could do well over the
next few years.
The other possibility is that the boom will prove fleeting. Perhaps
the recent productivity gains will peter out (as some measures suggest
is already happening). Or perhaps the world's major economies will
slump in the next few years. If something along these lines happens,
stocks may suddenly start to look very expensive.
In the long term, the stock market will almost certainly continue to
be a good investment. But the next few years do seem to depend on a
more rickety foundation than Wall Street's soothing words suggest.
Many investors are banking on the idea that the economy has entered a
new era of rapid profit growth, and investments that depend on the
words "new era" don't usually do so well.
That makes for one more risk in a market that is relearning the
meaning of the word.
E-mail: leon...@nytimes.com
Vid...@tcq.net
unless their value is a house of cards.
bingo, it is something i to have thought also. after the collapse in
2001, the real value of the markets should have been much less than
they fell to, but under the conservatives, they pumped it up again
with our money. just like 1987, and 1998, and what they are attempting
to do today.
every 20-30 years free market hucksters raise their ugly heads. and
the gullible follow.
> That makes for one more risk in a market that is relearning the
> meaning of the word.
>
> E-mail: leonha...@nytimes.com
com...@webtv.net
matter if the president, or congress or senate is democRAT or
republican. to say so shows your stupidity, mr. video.
i can say, the only time i ever really have lost money in the
stockmarket is when i took a "wild chance" on an iffy stock lookng for a
big return in a short amount of time. i knew that going in and it is my
money and i can rsk it any way i want if i chose to do so. most of the
time i invest in companies that have growth, no real debt and a low PE.
but, in the few times i did take a crazy chance , i can say i did hit it
big a few times and am way ahead on my speculation portfolio.
A Socialist is "just a Communist in a Free Country" !
Bill Reid
<com...@webtv.net> wrote in message
news:2869-46...@storefull-3173.bay.webtv.net...
> personal greed is the way people lose money in stocks.
So should I try to keep my greed impersonal?
> i can say, the only time i ever really have lost money in the
> stockmarket is when i took a "wild chance" on an iffy stock lookng for a
> big return in a short amount of time.
So how come you're such a big loser in "Lowbrow"'s long-term
(for me, one year is "long term") stock-picking contest?
---
William Ernest Reid
Post count: 747
GoForward
Neocon is "just a PC term for fascist !"
Blash
"P/E Ratio Close to 27. That's Higher Than at Any Other Point in..."
gofo...@fastmail.fm wrote on 8/15/07 9:59 PM:
<<Neocon is "just a PC term for fascist !>>
That's a really fascinating bit of info, BUT, are you sure you are replying
to the correct N/G, thread, etc.???