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.

Stocks in S&P still reasonably valued, no bubble here.

I have already read one "expert's" comment that the new S&P record 'makes him nervous'. Per the linked article, the S&P's stocks are 45 % cheaper than in 2000. No bubble here. Let's move forward.



Bloomberg.com: Exclusive

The Correction has been Corrected!

So, if the market has made back the ground lost due to the "correction" -- I despise that word -- does that mean that the correction was incorrect? Mark Hulbert discusses it.



February-March correction now completely overcome - MarketWatch

Bloomberg's Hauck & Xydias Discuss Low Global Correlations

This is important to you because when many global financial markets seem to be moving more closely together, investors and speculators both take note. We respond, or at least are concerned, in somewhat different ways. The diversification of foreign investing is important to each, but globally-diversified investors don't necessarily need to respond in a short-term-focused way. There are times when correlations track along more closely, like now, and there are periods when markets in different places move up or down together, but in differing degrees, and there are times when the correlations even become negative for a time. This can continue for extended periods of time. No sweat, to a more strategically-oriented investor. More tactically-oriented folks, and the speculatively-inclined, like those described in the Bloomberg article, always on the lookout for a way to shorter-term gains, can get somewhat lathered up over this, but that is the way things are, for now, and perhaps for awhile.



Bloomberg.com: Exclusive

Washington Post --"Puffing Up Performance? Accounting of Sales by Dot-Coms, Other Companies Increasingly Troublesome to Regulators"

Here in the USA we like to tell ourselves that our accounting numbers and corporate governance are the best. Well, the Europeans think we could do better, and ... I certainly hope that we don't see another round of stories about bad accounting at dot.coms.

The point? Investors and real managers need good numbers and reasonable, conservative accounting approaches. Only hustlers need juiced-up numbers.

Puffing Up Performance? - washingtonpost.com

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Two Great Posts on Financial Page

Barry Barnitz' Financial Page blog is just a marvelous resource. The quality of the content is consistently very high. I'll link to two posts here and add just a few comments regarding the pdfs he links to.

First,

Financial page: Morningstar Year End Commentary Report.

Morningstar's numbers confirm what so many have observed as to how the markets are doing now. Large-cap value and small-cap value US stocks did very nicely in 2006 and continue to do quite well, though the small-caps may be cooling off some. Large-cap growth stocks are now performing about equally well as the large-cap value, and are valued somewhat cheaply, at least relative to some of their historic peaks of valuation. All of this implies that a portfolio with some value "tilt" is still working well, though the potential for improved large-cap growth relative to value in 2007 may be there. The beauty of it all is that, just as you would expect, value investing is looking just like one would expect, sort of the "man for all seasons," and growth, when it has its day, will likely give you plenty of time to work it in in a measured way, if you are into tactical or mean-regression anticipation approaches. Small-caps, likewise, if they go cold for a time, have pulled very well for a multi-year period, and a period of time when they trail their large-cap brethren can be handled well either in a strategic or more tactical way, depending on one's pre-meditated portfolio approach. Sticking to one's approach is the hard part!

The second post, What Moves the National Retirement Risk Index? gets into the real issue for us all. Will we be adequately funded for retirement? As a young man, I confess, I just couldn't get serious about thinking about retirement. I couldn't. Each day was full of things to do, and retirement might as well have been in the next century. It will be!

If you are young and reading this, congratulations. You can take small, easy steps now which can make a great positive difference in you future and the future of those you love. Put what you can into your 401(k) each month. Sweat over investing it well. Don't try to time the market by leaving your money in the money market fund or bonds choices until you see a bull market. You won't see it until it's well underway. If you got burned in the bear market, it's been over for four years now. You could have made some money, perhaps one hundred percent or more, just with some well-chosen, diversified equity holdings. If you've been very risk averse, expecting a terrorist dirty bomb attack or some other disaster, the news is that it did not happen. Live in hope, not fear. These are the years for you to grow your money. Sure, bear markets happen, but you, as a long term investor, do not have to sell. You can take the long view, stay invested, and pull ahead. Market timers, as a group, fall ever further behind. It is a fact of financial life. Successful market timing is the financial equivalent of searching for El Dorado. It is not there. But you don't need El Dorado. All you need are time and some good markets. Get some knowledge. Read up. Learn about the one thing that really, truly works over time. It is called asset allocation. It is like the proverbial wisdom of the book of Proverbs being cried out in the streets, and being mostly ignored because it is not "sexy", it is not fast, it does not lend itself to exploitation by billion dollar brokerages ravenously hungry for revenues, in the way that failed ideas like technical analysis and market timing and even (gasp) "active management" do.

If you are older and thinking that you may be underfunded, well you have plenty of good company. Understanding the problem is the first part of the solution. If you are underfunded, guard your good health, and get a good night's rest, and go to work, one step at a time, to move toward fixing things up. There is much that can still be done.

S&P 500 P/E Still About 17, same as 4 Years Ago

This is good news.

In another Bloomberg story, via the always interesting and useful The Kirk Report (yes, by the way, the Unknown Advisor does read other things and see other websites!) The S&P 500 is still valued at about 17 times trailing earnings per share, just about where it was four years ago at the beginning of the current bull market.

Noteworthy, that's what it is. Earnings have grown and kept pace with the run-up of share prices, overall , during the bull market. My working conclusion, to this point: The bull market is intact, and probably not ready to quit for a good bit yet.

Remember, this was the P/E relative to trailing earnings, not projected or forecast earnings. It would be a lot easier to question a P/E based on forecast earnings.

The Unknown Advisor is not into market predictions, nor is he into short-term trading or technical analysis! If the economy is growing, (and it is, albeit not a strongly,) and if stocks are not priced at high multiples relative to historical valuation ranges, then why the angst in so much of what you read and hear?