Thursday, October 06, 2005



A basic stock market valuation measure is the Price/Earnings Ratio. And the biggest driver in Secular stock market cycles is the change in Price/Earnings ratios from high to low and vice versa.

The post today is from a Desert of the Real Newsletter from last summer. The Author wrote it during the week that the Guild Cinema in Albuquerque had its 1970s Cult Classic Movies Festival. So there is a distinctive 1970s retro-feel to the post. So let’s get down with some valuation rappin’.

Price/Earnings Ratio. What you Pay is What You Hope You Gonna Get, Suckah[1]

Price/Earnings Ratio is a fairly straightforward concept. It is the price of an investment divided by its earnings for a year. For example, if IDISALIE Inc. had $4 in earnings in the last year and the price of IDISALIE Inc. is $80, the P/E ratio would be 20. (80/4 = 20). If the price of IDISALIE went up, buoyed on news of better sales, to $90, the P/E ratio would rise to 22.5 (90/4=22.5). Earnings did not rise, but the price that investors would pay for IDISALIE was bid up.

Similarly, if the price of IDISALIE plummeted upon news that the CEO was caught cavorting with known and still-unindicted felons[2], the P/E ratio would fall. If IDISALIE fell to $72, the P/E ratio would become 18. (72/4 = 18).

The P/E ratio is an expectation of future growth and earnings, also. If IDISALIE ‘s earnings are expected to rise to $5.5 next year and investors bid up the price of IDISALIE, then the P/E will go up based upon the prospect of higher earnings. Conversely, if IDISALIE’s CEO’s legal troubles are expected to hurt the company’s performance, IDISALIE’s price will fall and the P/E ratio will go down.

P/E ratios can also be expressed for market indices or sector indices. The Price/10-year earnings ratio of the S & P 500 is currently at about 27. This is historically high and one of the reasons equity price growth has stalled and we are in the early stages of a Secular Bear Market[3]. Until P/E ratios fall into the low 10s or below 10, the market may not be poised for long-term sustained growth.

Jeremy Grantham is the chairman of GMO LLC, an investment firm[4]. Grantham is one of the top financial and investment minds in the world. He is also an excellent “synthesizer”. He can bring together financial trends or concepts into readable explanations of current conditions. In his July 2005 “Letter to the Investment Committee IV, Explaining P/E”, he discusses the factors that affect P/E ratios, commonly believed factors that do not explain P/E ratio levels, and why the P/E ratio of the market is historically high.

Grantham writes that the factors that have a positive correlation with P/E shifts are factors that relate to “investor psychological comfort”, or economic stability.[5] The three factors that correlate most closely in Grantham (and Ben Inker’s) model are, in order of significance:
1. Levels of profit margins. It is not the increases in profit margins, but the consistently good level of profit margins that increase investor comfort and correlate with high P/E ratios.
2. Stability of inflation around its “sweet spot” of 2.5% per year.
3. Stability of GNP growth.

Putting all of this together, Grantham and Inker’s model calls for the high P/E ratios we are presented with. The market is still over-priced and when the market falls to normal (and will almost certainly overcorrect, as markets usually do), stock prices will fall in value. And Grantham reminds us that his model “explains high prices, it does not justify them[6].” (Original Emphasis)

Reversion to the Means. Or the Maddening Götterdämmerung of Most Mortal Men[7]

Just as some men are Ford men, some kids are “Toy’s R Us” kids, Grantham is a reversion to the means guy. Grantham succinctly states:

“[E]conomic trends mean revert because there is a powerful and persistent normal return toward which capitalist competition strives, competing down handsome margins and P/Es and avoiding low returns until shortages develop.”

That’s the Fact, Jack.[8] If only Alan Greenspan could explain things that effectively. High P/E ratios will come down and stocks will become cheap again. And that is when the smart money should put all four feet and snout into the market trough. Grantham backs this up with some statistics.

Many studies show that the key to generating a good (or poor) long-term stock return is to consider when you initially invested your money. If you threw it all in March 2000, yuh been pimped. However, if you invest when P/Es are low, you’re in the Jack. Grantham and Inker divided the 10-year returns from all monthly starting points into five quintiles. If investors invested their money when investor comfort levels where low they have netted an 11% return. If they invested when comfort levels were highest (like today’s market), the compounded 10-year return was 1%. That’s not a typo, 1%.[9]

And Mr. Grantham has brought us full circle. Invest at the end of a Secular Bull Market and the following Secular Bear Market will devour your returns and maybe even some of your capital. Keep your picnic basket in the cabin until the Bear finally gives up and walks away, and there will be a banquet in a few years.

Finally, remember that there are opportunities in all markets, Secular Bulls and Bears, and Cyclical Bulls and Bears. Keep reading this Blog and the Author will share them with you as best he understands them.


[1] You must forgive the Author. The Guild Cinema is showing Cult Classic Films from the inimitable decade of the 1970s. The 1970’s was the last decade in which Walther Mathau wore a purple hat with a white feather or Cloris Leachman wore a halter-top. Perhaps it is best that way.
[2] Jack Abramoff and a yet-to-be indicted congressional leader from Sugarland, Texas, who shall remain nameless, or in a more Rovian sense, “unidentified”. FLASH UPDATE: This congressional “leader” from Sugarland, Texas has since been indicted.
[3] Please refer to the May and June 2005 editions of Desert of the Real for a discussion of the Secular Bear Market.
[5] “Letter to the Investment Committee IV”, p. 1
[6] Letter, p. 2.
[7] The Author means no offense to his female readers. It is just that the phrase “most mortal men” has good alliterative qualities. He has seen the film “Who Framed Roger Rabbit” enough times to appreciate good alliteration in a work of art.
[8] There’s that 1970’s cinema stuff, again. We all remember the 1970s, don’t we? Good times, guitars heavy with fuzz and wah, big cars, tight halters with big natural . . . uh, better not go there. This is a family blog. But there was something else in the 1970s. Recessions, a poor stock market, and double-digit INFLATION.

Many of us were and are still schooled to believe that prices of input materials (remember the oil crisis) are the drivers of inflation. The Author managed to show up for economics class one day when he was told that there were two types of inflation: Cost-push inflation (cost of oil goes up, so does the price of goods shipped by truck) and demand-pull inflation (everybody wants to buy a Cabbage Patch Doll so the price of the doll goes up). But subsequent reading and study is telling the Author that inflation is not an economic event, but a monetary event. This is probably a story for another newsletter, but the Author will cram it into this footnote as a farsightedness vision test.

The means reverting statement Grantham makes provides guidance on why inflation is not an economic event. When oil prices go up, markets and entrepreneurs react. They seek more oil sources, look for petroleum alternatives and make engines more efficient. Rational consumers also react, driving less and buying more efficient vehicles. Except in America, of course, where oil prices have not caused an economic behavioral reaction. In the inimitable American tradition, Americans use their credit cards to fill their tanks. Americans are deferring, and financing at usurious interest rates, the gasoline price increases. As a 1970’s loan shark film character might say, “If yuh gonna drive it Big, yuh gotta pay the Vig”.

Inflation is the monetary event where there is excess liquidity or stimulation in the economy. Monetary officials, like Alan Greenspan, hold vigil over inflation and try to limit inflation with a tightened money supply.

So back to the 1970s. Some among us may remember Paul Voelcker, the cigar-chomping Fed Chairman that President Jimmy Carter installed. Voelcker began an aggressive money-tightening policy that cut inflation, induced a recession and ended the 1970s. Alas, that was the 1970s. And as good-hearted tough-guy cop Baretta (played by Robert Blake) would say, “And dat’s duh name ‘uh dat tune.”
[9] Letter, p. 2.


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