9/25/02 WSJ "commentary" -- The Market's P/E Is Low, Not High
September 25, 2002
The Market's P/E Is Low, Not High
By MARC A. MILES
Bargain hunters remain glued to the sidelines by the
mantra that the market's price-to-earnings ratio is too
high. But bystanders beware -- today's P/E is already
very low. If you wait longer, you just might miss the
bull market.
Certainly, conventional measures of P/E look scary.
The Standard & Poor's 500 today, when compared to
trailing fourth-quarter, reported profits, appears
historically very high, indicating that the stock market is
overvalued. But this measure of value is flawed.
Markets price current and future, not past, earnings.
S&P 500 reported earnings are inferior to the
Commerce Department's after-tax economic profits.
And lastly, the market's P/E should fluctuate inversely
with interest rates.
Furthermore, the trailing fourth-quarter includes Sept. 11. Unless one expects that horrific economic shock to
be repeated again this year, those earnings numbers are inappropriate for comparing to current levels of the
S&P.
Unlike reported S&P profits, after-tax profits use actual corporate earnings reported to the IRS, not numbers
released to impress analysts, and companies do not overstate profits to the IRS. IRS reported earnings are then
adjusted to reflect true costs and to eliminate windfalls. Published after-tax economic profits have been
adjusted using replacement cost basis for sales from inventories and capital consumption. Furthermore,
stock-option costs are counted as they are exercised, and capital gains/losses in pension-fund assets are netted
out. The result: Numbers that are readily comparable over time and reflect true economics.
The third adjustment is to account for the substantial rise in interest rates in the late 1970s, and the equally
substantial decline since. The value of earnings moves opposite to interest rates. Given the choice between
stocks and bonds, as the 10-year rate falls a given level of earnings should be associated with higher stock
prices. P/E rises. This adjustment is accomplished by dividing P/Es by the inverse of the 10-year Treasury
yield. In high interest-rate periods, when P/Es are expected to be low, the adjustment will be relatively small. In
low-rate periods, however, when P/Es are expected to be high, the adjustment is large. Thus the P/Es are
"normalized" for the height of interest rates.
My properly adjusted numbers suggest that the current P/E is low by historical standards. In fact, at
yesterday's closing S&P of 819 and 10-year yield of 3.64%, the market's P/E is the lowest in the entire
33-year period examined. Even at an S&P of 900 and a 10-year yield of 4%, the ratio is at the lowest level
since 1978, in the middle of Jimmy Carter's economically disastrous presidency.
Hence, there is no historical barrier for a significant market rally. In fact, it would be logical that it would rally
from such a low P/E.
Equally important, today's seemingly high P/E calculated from trailing, reported S&P earnings should begin to
appear more "normal," even as stocks rally. If economic conditions did not change, profits would be expected
to rise by 30% to 40%. Moving forward in time, simple arithmetic dictates that past quarters of unusually low
reported earnings will be replaced by earnings at current or higher levels. The fourth-quarter trailing average of
earnings goes up and P/E falls. Furthermore, many of the accounting rules which contributed to such low
levels of recent reported earnings will now work in the opposite direction; e.g., bad debt expenses will decline,
while the rising stock market increases the value of pension plans, both effects boosting the bottom line of
report profits.
In other words, get ready for a rally. Those paralyzing high P/Es are just a mirage.
Mr. Miles is executive vice president of Laffer Associates.
Updated September 25, 2002
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