Value investors often cite low price-to-earnings (PE) ratios as good reasons to buy stocks. If a PE ratio is below its long-term average and you assume PE ratios are mean reverting, then the ratio should revert to its mean when earnings fall further or when the price goes up.
However, historical evidence shows that earnings revisions are actually positively correlated with PE ratios (see the chart below from RBC Capital’s Myles Zyblock).
Let’s think about this: if earnings are revised down at the same rate the stock price falls, then the PE ratio should stay unchanged. However, there is a positive correlation between earnings and PEs, not price. If you have a basic understanding of maths, then you will realise that this means prices must move at a faster rate than earnings in order for the PE to move.
This is troubling for investors because the implication of this correlation is that earnings revisions amplify price volatility.
[credit provider=”RBC Capital Markets”]
To be fair, value investors tend to be more patient and hold longer term positions than most other traders. And this chart does show some mean reversion, which means its possible to make money by going long low PE stocks and going short high PE stocks.