Cult of the Bear, Part 2

P/E Ratios Are Not Cheap

The chart below covers the S&P 500 and its P/E ratio over the course of 1982-2000 bull market. Note that the P/Es started at 7 and rose to nearly 50. The median P/E went as high as 32.

There are those who claim that P/E expansion isn't all that significant to market performance; they argue it is a function of falling interest rates. A better explanation is psychology: Something shifted in investor sentiment that made them willing to pay more than $7 for a $1 of earnings -- in fact, almost $50 per. That change is best explained by a sentiment shift related to perceived relative value.

Most investors do not think about P/E expansion as the lion's share of the market's gains. Instead, they credit a robust economy, technological advances, productivity gains, and (of course!) earnings improvement.

All those elements did have an obvious impact . By my calculations, they were responsible for about 25% of the gains.

But the biggest contribution of these elements was not to the bottom line; rather, it was to investor sentiment. This "fantastic four" allowed investors to rationalize higher prices: Aren't stocks worth more if the economy is doing well? Doesn't technology make companies more efficient? If workers are more productive, then earnings will be all the more better.

While rational, these are hardly easily quantifiable data points.

Multiple Expansion and Mean Reversion

So what does this have to do with this year's market performance? Nearly everything.

Do not forget that the process works in reverse, as well. Post-crash, there is an increasing unwillingness to pay more for a dollar of earnings. Indeed, that's why we are seeing the market making so little progress, despite all the "good data." Investors are unwilling to pay more for earnings. The machinery is spinning furiously simply to stay in place. Without share buybacks and dividend increases, market performance would be much worse.

This is the psychological issue referenced above. Why worry about corporate malfeasance, earnings misses and bad management? Instead, fix up your home and watch it appreciate! And, it won't get marked to market every day (less stress), and, unless you live near a toxic waste dump, it won't go to zero.

This explains how sentiment affects multiple compression. But does this process have a mathematical explanation?

Yes: Mean reversion is the process by which earnings ratios oscillate above and below its long-term average. And markets do not seem to stop on their means. Instead, they swing wildly above and below.

The accompanying chart shows we have been way above the historical averages for P/E ratios. From 1955 to 2005, the median P/E was 17. Stocks may not be terribly expensive at present, but they are hardly cheap by historical measures. An even more discouraging analysis comes from Clifford Asness of AQR Capital Management. He calculated the P/E ratios for the entire market from 1871 to 2003 at about 11. That suggests stocks are even less cheap (or more expensive) than is implied by our measure of "only" the past 50.

Source: Mike Panzner, Rabo Securities

Whether you take the 50- or the 132-year perspective, the theory of reversion to the mean implies that stocks likely will become even cheaper as P/Es revert to the mean -- and then overshoot.

P.S.: I know "P/E mean reversion" has been the mantra of the permabears since the bubble burst (if not prior), causing most to miss the rally from the October 2002 lows. But that doesn't mean they're entirely wrong or that the theory should be dismissed.

Over the long term, I do believe P/Es will ultimately revert back to average levels, after falling below for a period. But there certainly are going to be short-term opportunities within the longer-term reversion cycle and, unlike the permabears, I've made various bull/bear calls such as here and here.

Despite accusations from critics and inflammatory headline writers, I am not part of the "Cult of the Bear."

Forthcoming Conclusion

In part 3, I'll tie together the top-down approach from part 1 and the technical factors discussed above to show how I got to my 2006 forecast of Dow 6800 and S&P 880.