Recently much alarms have been sounded about the stock market’s high PE ratio, especially with the S&P500 Shriller P/E having exceeded 30.
In this article, we will examine what does a high PE ratio really mean and its significance. i.e is this a chance for us to short and make money? (Hint: It’s not so simple)
Firstly, the PE ratio that we commonly use is trailing P/E. This is obtained through taking the current price divided by the previous annual earnings. For the S&P500, we take the price divided by the trailing earnings per share.
What this gives is an idea of how much (in terms of multiples) are you paying for each dollar of earnings. i.e a PE ratio of 15 simply means you are willing to pay 15 dollars now for each dollar of previous earnings.
Warren Buffet has said it “Buy when people are fearful, sell when people are greedy”. So, this should be our golden ticket to becoming a billionaire, right? (I am very satisfied with just a 100 million, will take all donations). Is this the indicator that we have all been waiting for? An indication of over-valuation?
The story is honestly not so simple. If we decompose the equation, it works out to be like this.
SPX (price) = Earnings * Earnings Multiples. Therein lies the problem.
Problem 1: We do not know current earnings/ forward earnings
Let’s take our previous example. Previous year earnings are $1, the price is 30. Our trailing PE ratio is 30. Such an indication would point out that we are “overvalued”. However, what if earnings results for this year comes out and we are looking at $5 in earnings? The market would then appear to be extremely cheap as the PE ratio would suddenly just be 6x!
Historical earnings may not be a good guide to future earnings. The best example that I can point to was during the financial crisis when earnings simply collapsed. The P/E of SPX then went to 70 with SPX at just 800.
Despite the market being at such elevated P/E was it really overvalued?
Also, forward earnings expectations may not be a sufficient guidance of the eventual “realized” earnings. They are after all just analyst expectations (which can be revised multiples times in a year as well).
Problem 2: Earnings multiples considers future expected earnings
Investors are pretty smart. In general, people only pay up for huge earnings multiples only if they think they can still make money. In other words, they are expecting earnings to climb even further, thereby compressing the eventual earnings yield.
Because of this discounting mechanism, it is not so straightforward to argue that the stock market is overvalued simply on the premise of the PE ratio.
I have plotted out a chart of the S&P500 along with its associated P/E ratios. Ironically, the highest PE ratio to be found in this timeline was during the crisis when S&P500 was at its lowest.
Perils of shorting bubbles: The market can be more irrational than you can be solvent
This famous quote from Keynes sums it up quite well. Even during the tech bubble famous fund manager Julian Robertson (Tiger Management) suffered huge losses in shorting the overvalued “tech” companies.
So how can we use P/E Ratios?
Personally, I believe that the PE ratios provides you a good framework to think about valuations.
If multiples are high, that indicates potential investor sentiments for an improvement in earnings. If I believe that such materialization of earnings improvement is not incoming, then that would be a potential opportunity to go short, especially if I believe in a worsening of investor sentiment. i.e a fall in earnings alongside a fall in PE multiples to trigger a fall in the price.
The second way to look at the PE ratio is simply its inverse, which is the earnings yield of the S&P500. Through conversion to a yield format, we can then compare the equity yield against other assets, i.e fixed income to see which assets are more attractive.
Thus, for example, if the S&P500 yield works out to be 10% and the 10-year government bond yield is 15%, you can expect investor flows to prefer bonds (since the yield is higher and it is safer). This is also known as the FED model. I will talk more about this in another post.
At the end of the day, making money in public markets is extremely difficult. You are up against some of the most well-informed and trained professionals in the world. There are no easy short-cuts and while PE ratios may seem like a convenient way to think about valuations, there are much more nuances that we must take into account.
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