I am a little out of my element with this post and I hope those that know more will add some commentary.
It relates to a conversation I had with a friend not long ago. The gist of it was, “The market price-earnings ratio is at historic highs and we must all get out before it crashes.”
I am not a fan of single number analysis, but I will admit that a P/E of 25 is a little unnerving. We know what the number is, we want to find what that number means.
There is another way to look at P/E. “Earnings Yield” is one divided by P/E. Like an interest rate. In this case 4%. Sort of like real estate that is worth 16 times net rent, (Which he also believes to be crazy), a capitalization rate for real estate of 16 implies yield is 6.25%.
Always remember investments exist in a spectrum. If you consider everything you put in and accept in the investment, ultimately they all return the same yield on the money. Money is one part of the investment, usually a big part, but risk, liquidity, management, availability, skill needed to operate, tax effects and more also affect what you expect and what the marketplace offers as the rate of return and that affects the P/E ratio.
There are no absolutes in the investment world. All investments are made in the context of all my other choices. Bonds, stocks, real estate, commodities, precious metals, patents or whatever. I want to optimize my yield for a given set of inputs. and I don’t really care what does that. I cannot decide by looking at one number.
The question at hand becomes is P/E high given its current context?
I expect the “Earnings Yield” to be higher than the bond yield because of risk and variability. Liquidity and most other things are pretty much a wash. So probably yield and its inverse, the capitalization rate or P/E, can tell us what we want to know.
I found a data set for 1871 to the end of 2016. I downloaded the 10-year US treasury bill yield , the P/E and the dividend yield and then calculated the average for each year. This is quite simplistic but Bonds and large cap stock cover a large part of the investment space. The question I ask myself, given my inputs is this,”Would I rather own a 10-year treasury bill or an S&P 500 index fund?”
I found that the ratio of dividends to earnings yield is around 60%. There have been some years where it has been as low as 30%. 2010 and 2011 are the recent version of those. And, when the market is very low, it can be quite high. 229% in 2009. It was over 80% from 1930 to 1933 too. Earnings don’t change as fast as sentiment.
I found that from 1871 to 1958 dividends were always more than the 1o-year T-Bill rate, but from 1959 to 2011 they were always less. (Average ratio is 1.16, median is 1.19 with standard deviation of .66) There can be reasonable explanations for this.
- The bond rate is not tied tightly to economic reality and was too low in the early period.
- In the later period, bond rates were too high, or the stock market was dominated by businesses that were “growth” and did not pay dividends. Could be both.
- Share buy-backs may influence the ratios, too.
Since 2011 it has gone both ways and in alternate years.
If I take the earnings yield and subtract the dividend yield, I get something like how the business works. I can compare that to the bond yield and discover this part is about two thirds as much as interest. So when I buy a stock that pays dividends I expect to get an income stream that is not too different from bonds and I expect to have a business too. I expect that business to grow and with it my dividend stream. All good and in favour of stocks except for the possibility that my investment could be lost whereas not likely with a government bond.
Back to our question, “Is 25 times earning too high a valuation for the market?”
Answer: it depends.
In context of bonds, 25 times earnings is cheap. Bonds average 54 times earnings for 2016. 2 to 1. Historically that ratio is about 1.67 so if bonds were at 43 times or so, it would be average. Bonds at 2.3% instead of the average of 1.84% in 2016 would fit perfectly. They are 2.56% at 8 March, and have been close to that for the past 4 months.
The ratio of S&P 500 P/E at 26 compared to Bond P/E of 39 is .67 and the 135 year average is .7 so in relation to bonds the market is not too expensive. That could change as bond rates increase or if earnings fall.
All in all, if I think as stocks as one item in the basket of all possible investments, they look neither cheap nor expensive. So maybe it would be okay to keep them.
If P/E was 25 and bonds paid 10%, you would have to be an idiot to own stock and if P/E was 25 and bonds paid .1%, you have to be an idiot to own bonds. 25 is just a number. A low mark in Chemistry. A high score on the 8th hole. About average age when you get married.
Context provides meaning and meaning matters when making investment decisions. Context rules. Never forget that.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772