Friday, March 20, 2009

P/E Ratios: They Ain't What They Used to Be!

Price divided by earnings, right? Simple. No.

When you cannot agree on how to define the term "earnings" anymore, then it isn't simple. In the last few days, we have seen some pretty big guns in academic and "real world" finance utterly unable to agree on what the current P/E of the S&P 500 index "is" now. One man, who knows more than I do, says that earnings should be capitalization-weighted. The guy in charge of the S&P's own computation of the index's P/E, says, more politely, "Bosh!"

Forward-looking or, um, "not-forward-looking"? One extremely bright man who runs a hedge-fund-of-funds says that on his projection of very low earnings, we are headed downward, much lower, before the bear market bottoms out. Others, including one noted "perma-bear", are now very bullish, for about the first time in anyone's living memory, and . (He's been around a while.)

Can this humble (I'm so humble that I'm unknown,) advisor offer a thought or two on P/E ratios? Thank you, I will.

1. Earnings of individual companies are less reliable than they once were. There is scope under the accounting rules, despite what the accounting profession says, for company management to smooth out income in normal years, and to do things like really throwing in the kitchen sink in a bad year, so as to look better later.

2. Forward-looking earnings are estimates only. Evidence-based estimates, but still estimates.

3. P/Es of indexes are just composites, however you calculate them, of the individual constituants of the index. And they are less reliable measures of value at market extremes, both tops and bottoms. Take them with a big grain of salt. Beware of obvious extremes, like those during the dot.com or tech bubble. They are unsustainable. Perennially profitable companies, running current losses, cannot have meaningful P/Es. It does not compute. So how meaningful is today's S&P 500's P/E, no matter how you try to calculate it?

4. But what about this market crash? P/Es were not obviously at ridiculously high levels. We just had what one very clear-sighted observer called a "liquidity bubble". Individual investors' behavior was not the cause of this last crash. Crashes do need a catalyst, something to sufficiently upset the status quo. See point 5 below. Institutions, both investment banks and other players, like hedge funds, were in my opinion the primary cause. Bear Sterns had what? Something over 30:1 leverage. Others were about as bad or even worse. Borrowed money, leverage, deployed in "safe, risk-controlled" strategies, like very highly-levered huge positions in CMOs and CDOs. Bye bye, Bear Stearns, and friends. but they were hedged! Yeah, right. Hedges can fail when markets aren't working or if the other party is himself in too deep. And now we find out that the European banks were more levered than Bear Stearns? That, if so, is trouble, with a capital T. If Euroland has a really bad time, they tend to spawn very big conflicts over there. Russia is economically weak now, but Putin is no fan of liberty, and wants Russia's old vassal states back. Germany was weak too, in the early thirties. China and the rest of Asia are not without large problems now either. And trouble in a globalized world, tends to flow around, back and forth, rather like a tsunami.

4.1. But why did all asset classes and equities of all the developed and emerging markets fall? Simple, in hindsight. Massively overlevered institutional investers, in a state of crisis, had to sell whatever could be sold, to meet lenders' demands for payment, and in the case of hedge and mutual funds, to meet the horrified retail investors' demand for redemptions. So, the levered players dragged down everything except sovereign debt, such as US treasury securuties.

5. But wasn't it really the housing bubble, and the politically-motivated lowering of mortgage lending standards, and lax bond-rating and institutional credit-rating practices which caused all this? That was bad, bad indeed. And it would have all blown up in due course anyway. And yes, this was the catalyst.

And that's how we got where we are.

Oh. P/Es. They are just a tool, and not always a very good one.

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