My Apologies. I didn’t have my morning coffee when I read your message.

“My point was that a simple guide to PEs indicates their sensitivity to estimates of r and g, and that changes in those two inputs alone could have accounted for all market PE changes.”

Thanks for articulating your point and I do agree with it.

Perhaps you simply like to argue. My apologies, then, for being so agreeable.

Thanks for providing the Gordon Growth Model. While that model works well in theory, in reality it blows up spectacularly since small changes in g, r, or b cause the output, namely the P/E ratio, to gyrate wildly.

Of course, one of the key problems with your conclusion is that your basic assumption is wrong. B, or the payout ratio, IS NOT 25%. It is 33% currently!

Furthermore, in the 80’s, the payout ratio was much higher than 25 or 33%. From recollection, the payout ratio was greater than 50%!

Why don’t you put 33% in your fancy financial model and tell me the output?

RE: Kaleberg & (Higher) Taxes

I believe that you are forming a causal relationship between two variables without looking at other factors. From recollection in the late 90’s, there was something called the Internet that became commercially available. New businesses were formed and companies were prolifically hiring without abandon in order to enable this new technology.

The market in general did not go up since taxes were higher. The market went up because the market was attracting capital given this “new” technology.

RE: P/E Ratio and Long Term Interest Rates

There is a strong correlation between the P/E ratio and LT Interest Rates, assuming “clean” or “normalized” earnings.

Of course, if LT rates go into double digits, it is reasonable to expect the P/E ratio of the market to compress.

However, at the present time, it is completely unreasonable to believe that the P/E ratio of the market will miraculously go into the single digits.

As I said before, the market is neither cheap nor dear.

I’m surprised at how many people discount a return to single digit PEs. Many of the sharpest minds on Wall Street predict it. Even fear it. The blabbering crew of salesmen in the major financial firms tell you it’s always a great time to invest. They are harlots and charlatans never to be trusted. Many technicians, analysts, chief investment officers and more pragmatic firms became pariahs in 1999 and 2000. Many even lost their jobs or lost billions in business for being concerned the market would start a reversion to the mean. They were right and they were punished. There is no room for reason when your mission is to get more and more and more money into the company’s investment coffers.

There is a general conditioning of exhuberance from many of the “younger” investing public, fund managers and financial professionals, most of whom haven’t seen the bear very often sans a brief visit in 2001/2002ish. And one hell of a visit at that. The old guys and gals were the ones puking their guts out in 1987 and many times before when the bear made many more regular visits. 20% returns are not a God given right.

Historical analysis of equities should go back 40-50 or even 100 years to truly understand economic, sentiment and intermarket analysis in my opinion. While I am long term cautiously positive, these responses scare me to death. Many of you might want to make a visit to a site you’ll love. http://www.nofear.com Buy a t-shirt and flaunt your exhuberance!

We are at likely ends of some very significant trends that should bring more cautiousness, suspicion and fear. But, nothing convinces someone any better than experiencing those changes in their wallet. Time will tell.

Of course, I have my hopes. If the tax cuts lapse in 2010, the economy should take off a few years later in response. Hey, it worked the last time several times that taxes went up. It could work again.

In 1980, 10-year rates were running 12-14% and inflation at 8%, so real long rates were maybe 5%; with an equity premium of 2%, that gives you an r in real terms of 7%. Real GDP growth through the ’70s pushed 3.5%.

P/E then is 25%*(1+3.5%)/(7%-3.5%) == 7.4.

1980 P/E per a simplistic ddm should have been 7.4 — damn close to where it was.

In 2005, 10-year rates are running 4-5% and inflation at 2.5%, so real long rates are maybe 3%; with an equity premium of 2%, that gives you an r in real terms of 5%. Real GDP growth through the ’90s pushed 3.5%.

P/E then is 25%*(1+3.5%)/(5%-2%) == 17.3.

2005 P/E per a simplistic ddm should have been 17.3 — damn close to where it is.

The market is trying to tell you something all right — real rates are lower now than they were in 1980.

That’s really almost all there is to it.

Why are you posting a grah from 2002?

(BR: To show th Bull market P/E peak — The 50 year chart of this, up to 2005, is here: http://bigpicture.typepad.com/comments/2005/12/pe_vs_sp_500_50.html)

The current P/E ratio on the S&P is almost 19x ttm EPS, as of September 2005. When one includes Dec 05 EPS, which is an estimate, the P/E ratio on the S&P is 17.9x ttm EPS. (Source: Standard and Poor’s website, you can click on the link: http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS)

I believe that the only conclusion that one can make is this:

1. At 7x ttm EPS, the S&P 500 in the early 80’s, there was a great deal of pessism amongst the participants in the “market”.

2. At 32x ttm EPS, the S&P 500 in 2000, there was a great deal of optimism amongst the participants in the “market”.

As Mr. Buffett said, and I’ll paraphrase, you pay a high price for a cheery consensus.

At current levels, the S&P 500 is neither cheap nor dear and, furthermore, given the overall resiliency of our economy in view of high oil prices, war in Iraq, inflation concerns, yadda yadda yadda, the S&P 500 still managed to eek out a gain for the year.

After re-ordering the information, the market is trying to tell you something.

Are you listening?

But I am not sure in a rational market it will fall to old averages. A long term investor can look at the long term returns which are something like gnp growth + inflation + dividends and just getting covered for the middle item is worth more to most of us than it used to be, plus various mutual funds and etfs let one truly average the returns ofv the markets meaning much less volatility than if one selects a small set of stocks.

Still I think the market is overvalued. I just think it’s new average will be slightly higher.

the terminal value and continuation of the dividend tax reduction are uncertain. what is the status of recent congressional action to make permanent the dividend tax reduction?

and there is an election not too far away, and tax-cut extenders in the U.S. House face uncertain prospects.

Finally, the chart of the market PE is based on reported earnings. But if you use operating earnings the PE is significantly lower over the past decade. Who knows if reported or operating earnings is more accurate, but I suspect operating earnings are closer to the “truth”.