Yesterday, Peter Boockvar referenced two WSJ articles on P/E:  The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?

I believe these articles are asking the wrong question. Rather than wondering if the value of P/E ratio is fading, the better question is, “What does a falling P/E ratio mean?” The chart below will help answer that question.

We can define Bull and Bear markets over the past 100 years in terms of P/E expansion and contraction. I always show the chart below when I give speeches (from Crestmont Research, my annotations in blue) to emphasize the impact of crowd psychology on valautions.

Consider the message of this chart. It strongly suggests (at least to me) the following:

Bull markets are periods of P/E expansion. During Bulls, investors are willing to pay increasingly more for each dollar of earnings;

Bear markets are periods of P/E contraction. Investors demand more earnings for each dollar of share price they are willing to pay.

Hence, a falling P/E ratio is not indicia of its lack of utility. Nor is it proof of “Fustyness.” Rather, it suggests that crowd is still feeling burned by the recent collapse in prices and increase in volatility.

Thus, this is not about the market’s economic concerns, or sustainability of earnings. It is about psyche.

The 2008-09 crash follows (in order) the 2000 dot com implosion, the commodity boom and bust, and the Real Estate debacle. Is it any wonder investors are nervous? Their skittishness requires additional incentives to get them to purchase risk assets like stocks. Hence, the decreasing cost of owning equities as a natural result of the psychic pain of losses, still fresh in investor memories.

History teaches us that valuations typically become extremely attractive at the end of Bear markets. The P/E ratio — as well as the dividend yield, enterprise-value-to-free-cash-flow ratio,


100 Years of Secular Markets, P/E Expansion & Contraction

click for ginormous chart

Source: Crestmont Research

Category: Earnings, Psychology, Valuation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

23 Responses to “P/E Expansion & Contraction”

  1. VennData says:

    Once again, our esteemed host is correct.

    Also the house price can be thought of as a P/Rent ratio. And the government bond market? Well that’s getting you 40 times in your ten year/ intermediate bond fund. Let me know how you feel about THAT dusty old P/E ratio when the Fed, inevitably, starts raising rates.

  2. flow5 says:

    Lets see. One variable is given by Dr. Leland Pritchard’s (Ph.D Economics, Chicago 1933), Dow P/E Theory which states that during increasing rates of (1) inflation there will be lower highs & lower lows & vice versa.

    But in the current low inflation environment there is another more important factor – the expected growth rate of (2) real-output. Slower real gDp growth (stocks follow gDp), means, lower rates of growth in earnings (however defined), annual, trailing, discounted, etc. (or a “company’s total revenue less its operating expenses, interest paid, depreciation, and taxes”).

    Who’s going to reach out for stocks, when many market participants are anticipating something analogous to Japan’s “lost decade” for the U.S.?

  3. Mike C says:

    P/E expansion/contraction could be a function of demographic factors, specifically the MY ratio which is the ratio of middle to young (middle being the asset accumulators):

    In my view, this explanation makes sense both theoretically, and it is a great fit empirically and explains why P/E ratios were low in the 1940s and early 50s despite low interest rates. It also explains the magnitude of the 1982-2000 bull especially the final parabolic blow-off from 96-00 as baby boomers entered their peak asset accumulation years.

    This same theory suggests a bottom in P/E ratios in 2017-2018

    I’ve been a believer in the 17-18 year secular cycles since first seeing Crestmont’s research many years ago, but for a long time I questioned the “WHY”. Was it divinely ordained? This demographic theory of driving the expansion/contraction of P/E ratios over 18 years (roughly 1 generation) seems to tie it up nicely.

  4. santamonica says:

    It would be interesting to deflate the chart based on the value of the USD (historical values can be seen on wikipedia) to see market performance on a real basis and compare it to alternative asset classes…

  5. nemo says:

    Isn’t the real, though hidden, message of the two WSJ articles that the falling P/E ratio does not lead to the bullish story many people want to report, therefore they condemn the P/E ratio as fusty, old-fashioned, and out of date?

  6. mark says:

    History teaches us that valuations typically become extremely attractive at the end of Bear markets. The P/E ratio — as well as the dividend yield, enterprise-value-to-free-cash-flow ratio

    Does history teach that this can be observed/realized in real time at the moment it occurs? I think history teaches that the answer is no. Among the thousands of people predicting the economy and stock markets there will always be a few who are right and afterward will claim perfect foresight. This is nothing more than survivorship bias and 20/20 hindsight.

    In real time, P/E’s will look high at the bottom because analysts will have become pessimistic and project forward earnings too low (just as they project forward earnings too high at the top)

    In real time, a high dividend yield will look like a prelude to a cut in the dividend – will you know that the bottom is nigh and dividend cuts are about to stop? Probably not.

    So good luck with that strategy.

  7. machinehead says:

    ‘P/E is about psyche.’

    It is, but it’s also about inflation and interest rates, which track each other. Recent examples shown on the chart are the rising-rates bear market of 1966-1981, and the falling-rates bull market of 1982-2000.

    Adjusting for the usual equity risk premium, the E/P [earnings/price] ratio will be arbitraged to be competitive with prevailing interest rates.

    Since long rates are about as low as they can go, over say a 10-year horizon, one can expect rising rates and P/E contraction.

  8. willid3 says:

    maybe the PE is reflecting the lower and lower revenue that companies are earning? with even less of chance in the future for more?

  9. dead hobo says:

    Thank you, finally!

    This is a sweet piece of analysis.

    The log chart makes it a little hard to estimate, but history projects that stock prices will fall a lot more before they improve. (Or prices will remain constant while average earnings rise across the board … unlikely.)

    If the Fed allows prices to fall to incomes then all parts of the economy will rise sooner than later (still, probably, too far into the future for most.) Otherwise, going Japanese will create a long long malaise that makes predictions impossible.

    It’s all up to the Fed to do the hardest thing it’s ever done … stop trying to manipulate prices. Just keep it’s hands off. Let the invisible hand work without fucking things up.

  10. dead hobo says:

    PS: Look at volume today. Even the computers can’t get out of bed. What happens when high velocity meets nothing to pump? Biologically, a heart attack or stroke comes next. Unless the 1st string comes back from holiday, assuming they are on holiday at this time, look out below. (or, the markets retain price on virtually zero volume, caused by odd HFT program anomalies, creating something really special for the market pumpers to explain.)

    Interesting times.

  11. Captain Jack says:

    I like the wisdom of Dickson G. Watts here: “Learn principles. Facts will then fall into their relations and connections.”

    Long-term investors tend to think of a stock as a discounted stream of future cash flows. And so the P/E ratio is, essentially, a measure of how much investors are willing to pay for that discounted future cash flow in a business they want to own (with a good helping of uncertainty, or ‘risk premium’, on top).

    From this perspective a P/E ratio isn’t “good” or “bad” or even a standalone indicator of any great merit, so much as a rough proxy for what investors are willing to pay, with all the other stuff — uncertainty, opportunity cost, credit availability, risk appetite — factored in.

    So what the Crestmont chart is really saying, when you take a step back, is not that bull and bear markets are driven by P/E ratios per se, but rather that 1) as a basic measure of how much investors are willing to pay, the P/E ratio simply and clearly reflects whether investors are feeling tight-fisted or generous, and new bull or bear markets tend to begin after the pendulum has swung to an extreme.

    For a real bear market to get underway, then, assets have to be expensive (in terms of what investors are willing to pay for discounted future cash flows). For a real bull market to begin, in contrast, assets have to be cheap on a discounted cash flow basis.

    The nice thing with getting down to the nitty gritty is that, once one has the principles in place, facts fall into “relations and connections” as Watts suggested. There is less need to rely on complicated cycle theories or wonky overlays.

    My .02 is that the hemming and hawing over the P/E ratio now comes from a bunch of partisan observers who don’t like the implied message that markets are sending, which is rooted in one simple observation:

    An economy that is historically driven by 70% consumer spending is going to be in a world of hurt when, after a 25 year leverage and debt binge, consumers have been box-canyoned into an involuntary forced savings program at the same time middle class jobs are disappearing, housing is cratering, and government efforts to “help” are both crowding out private investment opportunities and strangling the historical job producing areas of the economy with legislation and red tape.

  12. philipat says:

    And the taliking heads who nowadays invariably calculate P/E’s based on Operating earnings, as opposed to GAAP (As reported) earnings, with the sole purpose of understating P/E’s to make stocks seem cheaper than they actually are, don’t do anyone any favours either.

    The average secular Bear is about 18 years, so see you again in 2018? Bears usually end with single digit GAAP multiples so S&P 800 or thereabouts?

  13. cognos says:

    So why does the chart PE say 15+? Current PE is much lower and bottomed close to 12. This also means many stocks are sub 10.

    When PE bottomed like 10x in Mar 09… then many names went up 3x, 5x, 10x or more. Why set that up again?

    Market is almost exactly flat YTD (-7 bps on SPX)… its setup for a 50% bounce. Back-to-school will be better than expected and the holidays will be huge.

  14. cognos says:

    Plus its a great stock pickers market. AAPL continues to be a no brainer. There are many other good plays that will continue to crush and buyout candidates everywhere.

    Check out NFLX, CMG, LOGM, AKAM, GMCR, PCLN, CTSH, CTXS. Lots of winners. Lots of good companies are very cheap right now, so practically everything probably works the next 6 months.

    I smell fear, and it smells like opportunity.

  15. Captain Jack says:

    AAPL a no brainer? Really?

    At a $240B market cap (70% of Exxon Mobil) with the Android outselling the iPhone in H1 of this year?

    I suppose GOOG at $700 a share was a no-brainer too…

  16. philipat says:

    I rest my case!!

  17. tom brakke says:

    Great piece.

    I included a link to it and some comments about it in a valuation special edition of “research puzzle pix.”

  18. ToNYC says:

    The secular chart shows more % growth in each period indeed, but the purchasing power of the dollar since 1940 has suffered an order of magnitude tumble. The number one cash flow generator is crude oil, gasoline, diesel and gasoline for one has gone from 0.25 to 3.00
    So maybe making money from growth is a secular illusion that financial engineers chase; a chimera as it were.

  19. cognos says:

    Uh, good luck with that AAPL v XOM comparion. Its just dumb. XOM had more sales and earnings 5 years ago than this year. AAPL has 5x growth on one and 10x on the other.

    AAPL will end next year with $100/shr in cash.

    The “valuation” point is silly. The “android” point is even worst. “Android” is an operating system developed by google and put on phones made by a dozen different companies. There are something like 1B mobile phone sold yearly… AAPL’s run rate is prob 50M, so thats 5% mkt share (of a growing market). That can triple pretty easily.

  20. cognos says:

    Hey, gasoline price guy… another dumb manipulated stat. Gas prices hit $1.50 in the 80s. Last week average prices were $2.59/gallon. This is trival, its up 80% in 20 years… and a poor investment. It will probably get worse (oil peaks then declines for a long, long time. Nat gas is abundant and down 80% from peak in 08. Alt energy is rising fast.

    If you use poor data and bad stats… its very hard to make money.

  21. [...] September 10, 2010 by greenbackd While the WSJ is prepared to consign the PE ratio to the dustbin (see The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?) Barry Ritholtz is one of the few actually asking the question, “What does a falling P/E ratio mean?“ [...]

  22. gemfinder says:

    P/E makes more sense when you recognize it is just a special case of present value:

  23. Captain Jack says:

    I didn’t say Apple was a raging short, but rather questioned the notion that buying AAPL could truly be considered a “no brainer.”

    The only real point of the Exxon comparison is that XOM is one of the largest market cap stocks on the planet, involved in finding and distributing the most important commodity in existence, and AAPL is, uh, a consumer tech company.

    Trees don’t grow to the sky — though growth investors seem to frequently forget this — and meanwhile the AAPL share price has gone sideways for six months. So one has to at least wonder, with love and adoration for AAPL widespread throughout the land and the name on virtually every “high conviction buy list” disseminated by the Street, the degree to which all the rosy scenarios are already priced in.

    In other words: It ain’t the horse, it’s the odds you get on the wager…