I’ve written on the blog about the high Price to Earnings Ratio in the market right now – as you can see on the image above, from a historic viewpoint, we are at one of the highest levels in history other than during the dot.com crash and the subprime crash. Its a funny thing, the peak reading during those crashes are after corporate earnings have fallen to minimal levels but prices hadn’t yet fallen to compensate for it.
We have had 18 months of earnings contractions while the prices for stocks have continued higher. In other words, if you look at the P/E Ratio, you can easily see why it is climbing: we have increasing prices (P) and falling earnings (E) so mathematically in a fraction, when the numerator is increasing and the denominator is decreasing your result is a larger number.
It dawned on my, though, that I haven’t really explained the math behind WHY high P/E ratios are a bad thing, and it all boils down to future expected returns.
As one of our clients like to say when he stops by the bank: buy low, sell high. The reason is that you make more profit when you for a price that is higher than where you bought, and the greater the spread between the buy price and the sell price is what yields you more profit.
Concepts like this seem simple but there is a real mathematical relationship between low and high, and you can predict what your returns will be using a formula developed several years ago by John Hussman. I turned the formula into an excel spreadsheet so that I could project what future returns for the stock market will look like based upon today’s P/E ratio and one assumed to be in place at some point in the future.
If you look at the full sized view, you will see that this formula includes the historic stock market growth rate using the S&P 500 Index to represent the market, the dividend yield for that index, an assumed 10 forward investment horizon, the current P/E ratio for the index and the forward P/E ratio for the index from today’s Wall Street Journal Online.
You can see that using the formula shown on the spreadsheet, with the P/E ratio at today’s elevated levels, we can expect an average annual total return on the S&P 500 of 4.02% including dividends, significantly less than the historic average of 8.69% (you can see the calculation of that return in the pale yellow box on the right side of the image. You can see that buying at these elevated levels depresses future returns.
But what happens if we have a market correction and the forward P/E normalizes to its historic reading of 15? Here is that calculation:
All else being equal, a correction in the stock market that dropped prices so that they caught up with earnings (decreasing prices and decreasing earnings in this scenario), your forward expected average return for the next decade is 2.23% including dividends (which are estimated to be 2.01%). Buying near historic high valuations has a big impact on your future returns.
However, just as you might expect, if you are brave and buy into a correction when the P/E has fallen to near-bear market lows of 7, and wait for it to grow back to the historic average of 15, your results are completely different:
In this blog, when I talk about the risk/reward ratio (I know I have and I likely didn’t explain what I meant to an adequate degree) this calculation is a good example of it. Buying now when the valuations are high mean you are assuming the risk that the P/E falls toward its historic average but your expected return is barely above inflation.
But by buying when the market has corrected at a low valuation (albeit when its very scary to put your money into the stock market) and waiting for the market to just normalize to historic average valuations, your risk is low but your expected return is exceptionally high.
For this reason, we are maintaining our cautious stance on the market, being opportunistic when we get short-term pull backs and putting cash into the market, but being prudent and taking cash back out of the market when it moves back higher. When will we get the big correction? No one knows but you have to be prepared and invest your money wisely, buying low and selling high, not the opposite. Its better to be wise and smiling than greedy and crying.
For all you classic rock fans out there, I’ve been listening to Willies Roadhouse on XM Radio – so bear with me as I play some of my favorites from there before we return to Styx, GNR, and other popular choices here on the blog:)