Price/earnings (PE) multiples are standard market metrics. They're ratios that tell us how much investors are paying for a company's earnings, or the total earnings of a market benchmark.
For example, a PE ratio of 15 means that, if a benchmark's earnings total $100 when the earnings of each stock in the benchmark are added together, investors paying a 15 multiple of earnings are paying $1,500 (15 x $100) to own one share of each of the companies in the benchmark.
Right now, PE multiples are way above their historical norms. That's got lots of analysts questioning whether stocks are overvalued and headed for a correction.
But what if PE ratios aren't what they used to be?
If they're different, how are they different? And based on where they are today, are they warning us or misleading us about the market?
These are important questions to ask. It's even more important to understand why it's time to question PE ratios and what they may be telling us about where the market's headed.
Read on to understand what's changed and how what happens next will depend on President Trump's policies...
A Sign of the Past
Lots of Wall Street analysts are saying, "Stocks are overvalued and overpriced."
What they aren't saying is that the reason they're overvalued may be that they're using old valuation models based on measures that don't apply in an equity world that's changed.
In traditional terms, equities are expensive. They are overvalued based on the Dow's PE multiple of 20.97 on Wednesday (according to The Wall Street Journal) compared to its historical average of 15.45 (that's according to Bloomberg).
It's important to note that these numbers are determined by trailing 12-month earnings, meaning actual earnings and not 12-month forward earnings estimates.
On a PE basis then, the Dow Jones Industrials could be viewed as being 35.73% overpriced.
Figures released by Robert Shiller put the S&P 500's PE ratio on Jan. 26, 2017, at 25.78, while its historical 12-month median trailing PE is 14.65.
That means the S&P 500, based on PE valuations, is 89.62% above the level history says it gravitates towards.
But PE multiples aren't what they used to be. Sure, they're calculated the same way, but they don't have the same relevance they used to and therefore aren't always going to be accurate barometers of equity valuation.
Take a look at the trailing PE on the S&P 500 over the past five years:
- Jan. 1, 2012: 87
- Jan. 1, 2013: 03
- Jan. 1, 2014: 15
- Jan. 1, 2015: 02
- Jan. 1, 2016: 18 (estimated)
In other words, price/earnings multiples have been rising steadily.
What seems frightening is that investors aren't paying more for rapidly increasing earnings. They're paying more for incrementally growing earnings, if not flat earnings.
Take a look at the S&P 500's earnings over those same five years (courtesy of New York University's Stern School of Business):
- 2012: $102.47
- 2013: $107.45
- 2014: $113.01
- 2015: $106.32
- 2016: $108.86 (estimated)
That means that over the same period, while PE ratios have been going through the roof, earnings from 2012 to 2016 rose only 6.24%. The average of the benchmark's earnings over that five years is $107.62, meaning average earnings grew by only 1.15%.
So why are investors willing to pay higher PE multiples for barely improving earnings?
The Cards Are the Same, but the Game Has Changed
Here's the deal.
Because interest rates have been manipulated so low for so long by the U.S. Federal Reserve, investors have been reaching further and further out on the investment risk curve to generate any kind of meaningful risk-adjusted returns.
That's put fixed-income investors onto the equity risk curve and moved equity investors further and further out along that risk curve, as measured by rising PE ratios.
As long as the Federal Reserve's been promoting "the wealth effect" and cheerleading equities higher - including reacting to their every swoon by jawboning investors back onto the field - investors have been willing to pay more and more for unimpressive earnings.
The reward hasn't been higher earnings and greater net profit at companies, which would justify higher PE multiples, to a point. It's been appreciation of equities due to multiple expansion.
Federal Reserve backstopping of equities used to be called the "Greenspan put"... then the "Bernanke put"... now it's the "Yellen put."
While a put is a type of options contract, its use here means successive Fed chairs have been ready and willing to prop up securities markets by lowering interest rates.
Looking in the rearview mirror, it's clear to see what's happened, how it happened, and why investors are willing to pay higher prices for equities.
There hasn't been much risk in holding them, so they bid them up.
Well, we're in a different place altogether now.
The Fed has raised rates and they may raise them again, and then maybe again.
Propping up the markets may not be the Fed's first interest these days... especially on account of Donald Trump's criticism of the Fed, and Janet Yellen in particular.
If you didn't get the memo that rising PE multiples didn't matter because we had been transported to an alternate Fed Universe, it might be time to look at what's being written on the walls along Wall Street now.
Sky-high PE ratios may be misleading and a warning sign if President Donald Trump and his administration's efforts to replace the Fed's multiple expansion policies with real growth policies fail to blow wind into the sails markets have been coasting on for years now.
Sincerely,
Shah
The post This Market Correction Omen Just Isn't What It Used to Be appeared first on Wall Street Insights & Indictments.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.