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Strategies & Market Trends : MDA - Market Direction Analysis -- Ignore unavailable to you. Want to Upgrade?

To: edward miller who wrote (47822)	4/24/2000 12:58:00 AM
From: Michael Collings	Read Replies (7) \| Respond to of 99985

I'd like to comment on the discussion of P/E's. Yes the historical range prior to this mania was a high of around 21 and a low of 8 on the market overall with the average around 14 or 15. Since I'm an old timer, let me explain just why these historical p/e's were so important and why they will come back to being important again when the concept of momentum investing or "what's working now" investing runs its course. For many of you this is going to be a lesson in Investing 101 and you need not read any further. But for those of you that feel fundamentals no longer matter, this may be a needed refresher course. P/E's have always been a way to evaluate the merits of an investment. Stocks trade at a multiple of earnings and take into account future earnings. The old rule was that the P/E should reflect the company's growth rate, ie., if a company was growing at a 20 percent growth rate, then a p/e of 20 to 25 was in line with fair value. In bull markets the p/e might go higher and in a bear market the p/e might go lower. Along the same lines was the E/P, ie., the actual return on investment. A company earning $1 and trading at a price of $15 (a p/e of 15) was returning 6.66%. I'm excluding dividends in this example. The e/p equation becomes important when factoring in interest rates, ie., when interest rates are falling the return on stocks is greater and if everything else remains unchanged the value of a stock is greater. In that instance a stock earning $1 (not taking into account potential growth) would be worth more than the previous market before rates were dropped. Conversely when interest rates are rising, it has a negative impact on stock values. We're just talking about returns here. What exactly is the company returning on your investment. When Cisco was trading at a p/e of 200 the e/p was 1%. How many years at a 30% earnings growth rate would it take for Cisco to return an earnings yield equivalent to a 6% Government bond? About 9 1/2 years. So when Cisco was trading at a p/e of 200 it was discounting 9 1/2 years of future growth in its price. Why would anyone think that was a good risk? Heaven forbid that it didn't make its 30% growth in any of the 9 1/2 years. Today the s&p has corrected back to a p/e of around 25. What does that mean? Are stocks cheap? By historical standards, no. In fact, it is still at one of the highest levels in history. AND interest rates are RISING. Can the S&P earnings grow at 20% in this environment? What happens if the earnings actually go down. Look at stocks trading at p/e's of 8; they are telling you what's going to happen to their earnings.` Even in a momentum investing environment, there better be earnings to back the values. Which brings me to the last point. Way back when..... when p/e's averaged 15, the earnings were real earnings without all the accounting gimmicks that go on today. If the old standards were still in use, I suspect the p/e on the market would be much much higher.