P/E Ratios--Ignore At Your Own Peril
comstockfunds.com
In recent years it has become fashionable in some quarters to denigrate valuation as a tool in gauging the probabilities of future returns in the stock market. A recent study by Ned Davis, however, indicates that ignoring valuation can be hazardous to investors’ financial health. Davis looked at price-earnings ratios of the S&P 500 from 1926 to the present, and measured subsequent returns over periods ranging from three months to ten years. In every period, investing when market P/Es were low resulted in significantly higher returns than investing when P/Es were high. For instance, investing when P/Es were 9.3 or under resulted in a three-month gain of 5.8% as compared to a loss of 2.5% when the P/E was 20.2 or higher. Moreover the spreads widened as the time period increased. Over one year, investing at the low multiple resulted in a gain of 13.2% whereas investing at the high multiple resulted in a loss of 1.4%. Going out ten years made the disparity in results even more glaring. When investing at a P/E of over 20.2, the ten-year gain was a meager 54.1% compared to a much higher 162.4% when investing at a P/E of under 9.3.
This is not to say that valuation is a precise tool to time the market. It does, however, provide investors with the probabilities of achieving various rates of return over different periods. Currently the S&P 500 is selling at 46 times 2001 estimated reported earnings of $24 to $25, and 26 times “normalized” earnings of about $46. If earnings increase at the historical annual average of 6%, earnings in 2012 would amount to about $87. If we give that an historical multiple of 15, the S&P 500 would come out at 1305 in the year 2012, only 13% above the present level. In the near term, when we look at the late 90’s economic and financial bubble, the record debt levels, low savings rate and vast overcapacity, we believe that the current high market multiple places the market in great danger of a precipitous decline. |
