This Market Correction Omen Just Isn’t What It Used to Be

7 | By Shah Gilani

Price Earnings (PE) multiples are standard market metrics. They’re ratios that tell us how much investors are paying for a company’s earnings, or the total earnings of a market benchmark.

For example, a PE ratio of 15 means that, if a benchmark’s earnings total $100 when the earnings of each stock in the benchmark are added together, investors paying a 15 multiple of earnings are paying $1,500 (15 x $100) to own one share of each of the companies in the benchmark.

Right now, PE multiples are way above their historical norms. That’s got a lot of analysts questioning whether stocks are overvalued and headed for a correction.

But what if PE ratios aren’t what they used to be?

If they’re different, how are they different? And based on where they are today, are they warning us or misleading us about the market?

These are important questions to ask. It’s even more important to understand why it’s time to question PE ratios and what they may be telling us about where the market’s headed.

Read on to understand what’s changed, and how what happens next will depend on President Trump’s policies…

A Sign of the Past

Lots of Wall Street analysts are saying, “Stocks are overvalued and overpriced.”

What they aren’t saying is that the reason they’re overvalued may be that they’re using old valuation models based on measures that don’t apply in an equity world that’s changed.

In traditional terms, equities are expensive. They are overvalued based on the Dow’s price earnings multiple of 20.97 on Wednesday (according to the Wall Street Journal) compared to its historical average of 15.45 (that’s according to Bloomberg).

It’s important to note that these numbers are determined by trailing 12-month earnings, meaning actual earnings and not 12-month forward earnings estimates.

On a PE basis then, the Dow Jones Industrials could be viewed as being 35.73% overpriced.

Figures released by Robert Shiller put the S&P 500’s PE ratio on January 26, 2017, at 25.78, while its historical 12-month median trailing PE is 14.65.

That means the S&P, based on PE valuations, is 89.62% above the level history says it gravitates towards.

But PE multiples aren’t what they used to be. Sure, they’re calculated the same way, but they don’t have the same relevance they used to and therefore aren’t always going to be accurate barometers of equity valuation.

Take a look at the trailing PE on the S&P 500 over the past five years:

  • January 1, 2012: 14.87
  • January 1, 2013: 17.03
  • January 1, 2014: 18.15
  • January 1, 2015: 20.02
  • January 1, 2016: 22.18 (estimated)

In other words, price earnings multiples have been rising steadily.

What seems frightening is that investors aren’t paying more for rapidly increasing earnings. They’re paying more for incrementally growing earnings, if not flat earnings.

Take a look at the S&P 500’s earnings over those same five years (courtesy of New York University’s Stern School of Business):

  • 2012: $102.47
  • 2013: $107.45
  • 2014: $113.01
  • 2015: $106.32
  • 2016: $108.86 (estimated)

That means that over the same period, while PE ratios have been going through the roof, earnings from 2012 to 2016 rose only 6.24%. The average of the benchmark’s earnings over that five years is $107.62, meaning average earnings grew by only 1.15%.

So why are investors willing to pay higher PE multiples for barley improving earnings?

The Cards Are the Same, but the Game Has Changed

Here’s the deal.

Because interest rates have been manipulated so low for so long by the Federal Reserve, investors have been reaching further and further out on the investment risk curve to generate any kind of meaningful risk-adjusted returns.

That’s put fixed-income investors onto the equity risk curve and moved equity investors further and further out along that risk curve, as measured by rising PE ratios.

As long as the Federal Reserve’s been promoting “the wealth effect” and cheerleading equities higher – including reacting to their every swoon by jawboning investors back onto the field –  investors have been willing to pay more and more for unimpressive earnings.

The reward hasn’t been higher earnings and greater net profit at companies, which would justify higher PE multiples, to a point. It’s been appreciation of equities due to multiple expansion.

Federal Reserve backstopping of equities used to be called the “Greenspan put”… then the “Bernanke put”… now it’s the “Yellen put.”

While a put is a type of options contract, its use here means successive Fed chairs have been ready and willing to prop up securities markets by lowering interest rates.

Looking in the rearview mirror, it’s clear to see what’s happened, how it happened, and why investors are willing to pay higher prices for equities.

There hasn’t been much risk in holding them, so they bid them up.

Well, we’re in a different place altogether now.

The Fed has raised rates and they may raise them again, and then maybe again.

Propping up the markets may not be the Fed’s first interest these days… especially on account of Donald Trump’s criticism of the Fed, and Janet Yellen in particular.

If you didn’t get the memo that rising PE multiples didn’t matter because we had been transported to an alternate Fed Universe, it might be time to look at what’s being written on the walls along Wall Street now.

Sky-high PE ratios may be misleading and a warning sign if President Donald Trump and his administration’s efforts to replace the Fed’s multiple expansion policies with real growth policies fail to blow wind into the sails markets have been coasting on for years now.



7 Responses to This Market Correction Omen Just Isn’t What It Used to Be

  1. James says:

    Good post, Shah!

    This is what I look for when reading investment articles. You put clear meaning into the price to earnings (PE) ratio concept.

    On New Year’s Day, I had luncheon at my sister’s home. She invited her neighbor, in his mid eighties, who is a successful stock investor. I listened carefully to what he had to say about individual stocks.

    He asked me if I know about a health insurer called United Health Corporation. I told him, “Yes, I know. Its price is sky high about 160, too high for me.”. He replied, “Forget price, look at value.. Revenues and earnings for this insurer are going way up as much as 50 percent in recent years.That is the kind of stock I buy..”

    I went back home and pondered, and still pondering, over what he said: look for “VALUE”. Do you make “value” the key decision maker in this kind of market?

    What is” value” and how is it measured for individual stocks? Is it return on investment (ROI) or is it return on equity (ROE)?

    I wonder if you could enlighten us and explain these two ratios like you did so clearly on the price to earnings ratio.

    The point is even if the stock markets are at all time highs, there are individual stocks that are still good buys if the investor focuses on ROI and ROE to make his decisions..

    . .

  2. Les says:

    If PE ratios no longer represent the length of time (years) investors are willing to wait to recover their principle at presently perceived risk, then what DO they mean…that hope is considered a real plan, that talk is more “real” than results, or perhaps that investors actually believe euphoria guarantees that a “greater fool” is sure to come forward to take the investment off their hands at a greater price?

  3. Jeff Biss says:

    That the value of equities is not tied to actual earnings or earnings potential, but merely on the expectation of someone being willing to pay more for a stock than you paid, means we’ve got a bubble.

  4. Edouard D'Orange says:

    What if PE ratios aren’t what they used to be? If they’re different, how are they different? And based on where they are today, are they warning us or misleading us about the market?
    Aren’t earnings now spread over fewer shares with all of the buybacks? If so, then earnings will be higher. And if there are fewer shares, and assuming the same demand, then won’t that necessarily push prices higher? I thought this was the direction that you were headed.
    As for P/E, isn’t the CAPE a better measure if you’re going to use a longer term (though back looking) measure?

  5. Joseph Maxwell says:

    This looks like another bubble about to burst. To me it has all of the trappings It’s time to bet on the collapse.

  6. fallingman says:

    There are no markets anymore … just interventions – Chris Powell

    Valuations mean very little in a world where central banks, including ours … can and do buy stock index futures and stocks themselves in order to prop up prices. And that’s just part of the program of manipulation they’ve undertaken.

    Traditional stock market analysis is more or less meaningless when the actions of central bankers … paying for stock with money conjured from nothing … override supply and demand dynamics.

    There’s nothing to stop them from doing a backdoor, defacto nationalization of all the larger companies listed on the exchanges. Would that drive prices higher. Hell yes. is it a good thing. Absolutely not. It creates a grotesquely distorted situation that will end in tears.

    And we sit back while this coup is going on, spending our time trying to figure out how to make a buck or two trading a gamed market rather than calling as loudly as we can for some kind of brakes to be put on the central banks and a return to markets where pricing is driven by supply / demand fundamentals.

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