From dshort.com: While we’re waiting for the start of the 2nd quarter earnings season, let’s take a look at the P/E ratio with the latest Standard & Poor’s data, based on 1st quarter earnings for 498 of the 500 companies (99.7% of the index value).
Are stocks cheap?
A standard way to investigate this question is to look at the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.
The “price” part of the P/E calculation is available in real time on TV and the Internet. The “earnings” part, however, is more difficult to find. The authoritative source is the Standard & Poor’s website, where the latest numbers are posted on the earnings page in a linked Excel file (see column D)…
The average P/E ratio since the 1870’s has been about 15. What is it today? With the S&P 500 currently hovering around 920 and the June reported earnings estimate of .48, the current TTM P/E is around 1900. That’s right: 1900! Of course this is complete nonsense. At the top of the Tech Bubble in 2000, the conventional P/E ratio was a mere 30. It peaked north of 47 two years after the market topped out. So a P/E ratio of 1900 with the index down about 41% from its October 2007 all-time hight can’t be taken seriously.
As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. “Why the lag?” you may wonder. “How can the P/E be at a record high after the price has fallen so far?” The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500. And Standard & Poor’s earnings estimates for July through September will give us negative annual earnings. A P/E calculated with negative earnings would flip the ratio past a divide-by-zero error to a negative ratio. Make that nonsense squared!
The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behaviour during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the P/E10 to a wider audience of investors. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic P/E10 average is 16.3.
The Current P/E10
After dropping to 13.4 in March, the June 2009 monthly average P/E10 has rebounded to 16.7 — a bit above the average. In fact, with the index hovering around 900, the P/E10 is dead on average. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren’t especially relevant (e.g., the difference between the monthly average and monthly close P/E10).
Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.
Where does the current valuation put us?
For a more precise view of how today’s P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? Over the past several months, the decline from the all-time P/E10 high has dramatically accelerated toward value territory, with the ratio dropping from the 1st to the upper 4th quintile in March.
A more cautionary observation is that every time the P/E10 has fallen from the first to the fourth quintile, it has ultimately declined to the fifth quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 600. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its ninth year.
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