Decades ago (1987) Elaine Garzarelli gained popularity when she saw one of her fundamental market measures get way out of whack. It was the sum of "interest rates" and "Price/Earnings Ratio." I don't know exactly which rate of interest or which P/E, but know she used a "magic number" of about 20 as her center point.
Small amounts above 20 and the markets were overpriced/bearish and small amounts below were bullish indicating an undervalued market.
I started tracking such numbers back then and even back checked data to 1982. I used Value Line's P/E since it covered 1700 companies of a variety of sizes. Historically I've used the 13 Week Treasury as my "interest rate" for my own calculation. I call this "Relative Valuation" as it gives a market value relative to competing near-risk-free yield.
Relative Valuation helps us judge whether a P/E of 12 is "good" or a P/E of 18 is "bad." For instance, A P/E of 18 and an interest rate of 2% gives us a sum of "20." Elaine would be pleased with that number as it's about in the center of the long term swings. How about the 12 P/E? Well, if interest rates are 10%, then a 12 P/E gives us a total of "22" which would be outside Elaine's normal range and be considered Bearish.
So, Elaine's brilliance was that she gave us a way to qualify Price/Earnings in a meaningful way. If Risk Free interest rates are very high, then P/Es need to be quite low to compete. (and visa versa)
So, where are we right now? Value Line's P/E has been hovering around 16 for quite a while. The 13 Week Treasury Coupon rate is ziltch. So the sum is 16+. This historically has been EXTREMELY BULLISH. However, we know that the short term interest rate is historically off-the-charts. So, what rate of interest would it take with the current P/E to be bearish?
If short term interest rates rose to somewhere at or above 6% this market would be considered overpriced and bearish. For the shorter term treasury rate to be at 6% and not have an inverted yield curve, longer rates would have to be higher than that. How much higher? The markets would be the judge of that. But for talking purposes, we could assume that 30 year mortgage money might be near the double digit level.
In September of 1987, a month ahead of the "crash", the Value Line P/E stood at 16.9 while the 13 Week Treasury Coupon Rate = 6.35% for a total of 23.25. No wonder Elaine was calling for a market correction. (BTW, Value Line's composite "yield" was 2.3% at the same moment - not very competitive with short term interest rates at that time)
By late November of 1987 things had changed rather quickly and dramatically. While Interest Rates had only dropped to 5.43%, the P/E of Value Line had descended to 11.4 giving us a sum of 16.83. This was a screaming Buy signal for Relative Valuation. Interest rates weren't bad, but compared to the relative value of equities, shifting $$$ to the stock market seemed a very good idea. (Value Line's "yield" composite had risen to 3.4% at that time and peaked at 3.6% a couple of weeks later)
Neither the 11 P/E or the 16.9 value were outrageous in and of themselves. But when combined with the prevailing interest rate we see a much clearer picture.
So, even if we attempt to use a "normalized" interest rate of say 4%, the market's P/E of 16 doesn't seem excessive at all. In fact it would put the sum almost dead center in the middle of the historical range. Currently Value Line's composite "yield" is only 2.0% right now. While not particularly bullish by itself, it isn't a bad number when compared to 0.117% yield on the 13 Week Treasury.
I thought a bit of history might be a good thing to contemplate over the weekend. Hope this didn't bore everyone!
Best regards, Tom
PS: Reference points.......... Date Value Line P/E 13 Week Treasury Sum
04/23/2007 19.4 5.008% 24.41
03/09/2009 10.3 0.284% 10.58
05/23/2011 17.3 0.031% 17.33
08/08/2011 16.0 0.117% 16.12
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