In these uncertain times, it’s easier to know what you should not be paying attention to.
Today’s candidate for this dubious honor is the price/earnings ratio, perhaps the simplest and most popular of any valuation indicator. Often during bear markets the P/E ratio will rise, rather than fall, suggesting -- incorrectly -- that the stock market is becoming more, rather than less, overvalued.
This is illustrated in the accompanying chart. Consider the S&P 500’s P/E ratio during the global financial crisis. Based on trailing 12-month as-reported earnings, that ratio rose to over 120-to-1 by the time the bear market ended in March 2009. That’s far higher than the average ratio since 1871 which, according to data from Yale finance professor Robert Shiller, stands at 15.8.
In fact, that ratio at the March 2009 bottom was at a record high. Yet, far from being expensive, equities at that time represented one of the most historic buying opportunities in U.S. stock market history.
Something similar occurred in 2002, at the bottom of the bear market that was precipitated by the bursting of the Internet bubble. The S&P 500’s P/E ratio stood at around 29 at the top of that bubble in March 2000; it subsequently rose to 47 in that bear market.
To be sure, this pattern is not guaranteed to happen in every bear market. It’s mathematically possible for the S&P 500’s price (the numerator of the P/E ratio) to fall in lockstep with the index’s earnings per share (the denominator), thereby keeping the ratio constant during the bear market.
In practice, however, that usually doesn’t happen. Since the S&P 500 itself discounts future years in which earnings presumably will recover, it will fall less rapidly than EPS. And so, the ratio will rise as the market falls.
What’s happened to the S&P 500’s P/E ratio since the bull-market high in mid-February? I estimate that it has risen from 23.5 at that high to 25.2 today, an increase of about 7%. (These numbers are estimates, since the EPS numbers for the S&P 500 are reported quarterly, and with a time lag. There’s no way of knowing what the S&P 500’s trailing 12-month EPS was precisely on Feb. 19, or today.)
Furthermore, given that the S&P 500’s EPS will almost certainly fall in the current quarter, the index’s P/E ratio will rise even more in coming months.
What Should You Do About This?
The investment implication of this discussion is that P/E ratios aren’t particularly helpful during bear markets.
Could P/E ratios be resurrected by focusing on estimated future 12-month earnings rather than trailing 12-month earnings? Perhaps in theory, but definitely not now in practice. That’s because very few companies today have any idea what their earnings or revenue will be in coming quarters. That’s why many companies have withdrawn their guidance.
Another solution was recommended nearly a century ago by Benjamin Graham, the acknowledged father of fundamental analysis, and author of the investment classic The Intelligent Investor. He recommended averaging earnings over a “fairly long period in the past,” mentioning seven to 10 years. He argued that such an average “was useful for ironing out the frequent ups and downs of the business cycle.”
Yale’s Shiller based his famous Cyclically-Adjusted Price/Earnings Ratio (or CAPE) on the same idea. The denominator of his ratio is average inflation-adjusted EPS over the trailing ten years.
Not surprisingly, since this 10-year EPS average changes very slowly, almost all of the CAPE’s shorter-term changes are due to fluctuations in price. The S&P 500 today is 12.8% below its all-time high in mid-February, for example, and the CAPE over this period has fallen by almost precisely the same amount. So, to that extent the stock market has become less overvalued.
Note carefully, however, that the CAPE remains significantly above its long-term average.
You might think it’s odd to construct a valuation ratio whose short-term fluctuations are due almost entirely to price and are mostly immune to short-term changes in EPS. But the rationale for nevertheless doing so is that, when you invest in a company’s stock, you’re discounting a string of earnings many years into the future. And short-term fluctuations in earnings, such as what we have seen over the past couple of months, are a poor indicator of companies’ long-term earnings potential.