A recent article in the WSJ asserts that if you use the Price/Earnings (P/E) ratio as a general guide, stocks have gotten expensive. Although the author points out that that looking solely at P/E ratios might have some pitfalls, he doesn’t seem to really back up that statement.
He points out that the 60 year average P/E ratio for the S&P 500 is 16x. When you look at the earnings for the last 12 months, the P/E ratio jumps to 21x. Thus, stocks must be “getting pricey”.
I think most savvy investors take this assertion lightly; however, others should be conscious of the fact that one line generalizations about the valuation of the Stock Market are dangerous.
A different way to look at the P/E ratios referenced in the article is one attributed to Nicholas Molodovsky called the Molodovsky effect. He posits that in mature, cyclical industries, the P/E ratios will actually go up in bad times… and P/E ratios will go down in good times. It seems counterintuitive because most people agree that low P/E stocks are “cheap” and high P/E stocks are “expensive”. Once you think P/E ratios trending up or down over time instead of a snapshot of value, the effect makes some sense, but here’s a hypothetical example:
MG Motor Company sells much fewer cars during a recession than when times are good (all things being equal), so it’s certainly in a cyclical industry since company earnings are tied closely with the economy. Let’s assume their stock is priced at $30 in 2006, and $23 in 2007. Earnings go from $1.50/share in 2006 to $.90/share in 2007. The 2006 P/E is 20x and jumps up to 26x in 2007.
In this example, the earnings decline boosts MG stock into “expensive” territory, even though the share price dropped $7. This is because the percentage decrease in the denominator (earnings) is greater than the decrease in the numerator (price) from 2006 to 2007.
The point here is that one line arguments of valuation should at least be narrowed to a particular industry and not applied market wide. Very often there are opposing interpretations of commonly accepted measures of value such as P/E ratios — depending on the assumptions made, you could make a case that stocks are expensive or cheap!
Posted by moneynuggets 