Seeing Some Clarity on the P/E Debate

A recent story about historic price-to-earnings ratios for the S&P 500 generated some heated debate among readers. Many noted the P/Es cited in the original story conflicted with the message of money manager Ken Fisher's recent column in Forbes, in which he argued: "Correctly calculated, the market's highest P/Es ever were in 1920, 1932 and 1982."

According to the Web site of Yale professor Robert Shiller, the source for my story, P/Es in 1920, 1932 and 1982 not only were not among the highest ever, but each were less than the market's long-term average of around 14.

I finally caught up with Fisher on Tuesday and he explained that the P/Es alluded to in the Forbes piece were based on results including one-time write-offs and charges, rather than earnings based solely on continuing operations, which is what Shiller uses.

Notably, Fisher and co-author Santa Clara University finance professor Meir Statman used Shiller's data in a fall 2000 Journal of Portfolio Management article, "Cognitive Biases in Market Forecasts." Most academics use the same survey, which is spliced together from two sources: S&P's Statistical Service and Alfred Cowels' 1939 book Common Stock Indexes. But earnings from continuing operations without one-time items and charges "are not the way a human would react to earnings," Fisher said.

Remembering 1932

For example, Shiller's data showed corporate America as being profitable in 1932, resulting in a relatively low P/E ratio. But Fisher countered that IRS data showed a net loss of $3.7 billion for U.S. corporations in 1932, which was a pretty grim year for the economy. (Another source, the Commerce Department's Bureau of Economic Analysis showed corporate profits fell by $400 million in 1932.)

Similarly, Shiller's database showed S&P 500 earnings of $15.18 per share at the start of 1982, resulting in a trailing 12-month P/E of 7.83. But when write-offs are included, which Fisher argued "are earnings as people see them at the point in time," the earnings per share fall to about $2.60 and the P/E rises to 45.

Looking at the current environment, the money manager noted "gross operating profit margins are going up, not down," as Cisco's ( CSCO) results last night demonstrate. But in a difficult economic environment (and with heightened regulatory scrutiny on accounting practices), net profits are falling because managements realize "you write off everything this year while you can do it and blame it on the world," he said.

Obviously, there's an endless debate about the "best" way to calculate earnings. The point here is to clear up any lingering confusion about the differences betweens Shiller's findings and those of Fisher, who reiterated a view that "P/Es by themselves don't tell you anything" about where the market is going.

However, he did reiterate and discuss the bullish stance he adopted in mid-May. At that time, Fisher Investments, a Woodside, Calif.-based firm with $10 billion under management, reversed a long-held bearish stance and went 100% into equities.

Hanging on to the Bull

Fisher explained that the decision was based on proprietary tools the firm had developed to measure demand for equities. "We thought at the time demand had gotten too low but the 'new and improved' stuff we used to measure demand appears in retrospect to have been wrong," he said. "We thought demand was too low and it would regress to its mean. But it was not as low as we thought and it got lower."

Asked why he'd make such a big bet based on a tool that only had been back-tested and not used in the "real" world, Fisher replied that his firm has employed such "lab critters" previously, often with great success. Furthermore, "you build stuff and say 'I haven't had a chance to use it. If I don't now it might not be applicable for another 10 years,'" he explained.

Essentially, this was a "use it or lose it" proposition, and that's effectively what happened. Since May 15, the S&P 500 was down 21.2% through Tuesday's close and was off 0.4% as of 2:24 p.m. EDT Wednesday, in tune with modest drops for other major averages.

About 70% of Fisher Investments is benchmarked to the Morgan Stanley Capital EAFE Index, which tracks the performance of 900 securities in 21 countries. The index is down about 18% since mid-May, when the firm made a big trade in more than 2 million shares of the EAFE iShares, which are funds designed to mimic various indices.

Fisher Investments also took a stake in the Nasdaq 100 Trust ( QQQ) in early May, although the money manager denied being responsible for the then-record volume spike in the QQQs on May 15, as many traders suspected.

"In reality, we were done by then," he said.

Nevertheless, the QQQs are down by more than 30% since mid-May, and were recently off 2.1% Wednesday.

Despite recent losses, Fisher Investments is "a little ahead" of its various benchmarks year to date and has outperformed the EAFE Index by about 5% annually for several years, Fisher said. He did not provide specific year-to-date returns but said: "We started out ahead, and in the last two months have been hugging close to the benchmarks as they have been falling."

Still, Fisher expressed no regrets and is investing new inflows (as they occur) in the same way as for existing clients; fully invested with slight overweights in technology and foreign stocks. "I could be dead wrong but my sense is tech is beaten down and there's so much negative sentiment" that now's the time to get involved, he said.

In sum, "we're not taking huge bets against the market," Fisher continued, suggesting staying heavily in cash from 2000 until May 2002 was a bigger risk then getting aggressively long in May. That's because performance vs. benchmarks is how portfolio managers are measured. "Last year we were 100% cash-like and were up 4.5%," he said. "If we were wrong and lagged benchmarks by 20%, that's hard to make up."

Reiterating points from his Forbes column, Fisher suggested it's "getting late" in the bear market, and that while more downside could occur, "the time to turn bearish was two years ago, not now."

"I think this is about as beautiful a time period as you get" to invest in equities, he continued. "Normally at and around the bottom, people fixate on the negatives and can't see the positives -- they brush them off and focus on the ways things can go wrong. If the market goes lower, I'm content to hang on."

Many investors are taking a similar tack, including those who benefited from following Fisher's advice to get bearish in 2000 and are now questioning the wisdom of his recent bullishness. In this market, investors have little patience for even the few "gurus" who have been more right than wrong.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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