But The Market PE Is So Cheap!

First off, I have to say that I try to practice the mindset that I am neither bullish nor bearish on stocks or the economy. ie, I am open to change and not tied to a particular point of view. Those who point to massive debt or point to overspending by consumers as a reason to think stocks are going down simply to not have historical precedence on their side. Some of the biggest moves in the stock market have been when America had massive debt burdens. Much higher as a percent of GDP than today. The likely reasoning behind that fact is the worst may be behind us at those moments. People see accumulated trends, either positive or negative, and believe they will continue forever and they never do. Another data point is the stock market had a 400% rally in the Great Depression. So, today, just as people label Americans as spendaholics, we are most likely to become a nation of savers over the coming years. That may start out as a trend of spending less rather than sticking money in our mattresses starting tomorrow.

Are the markets cheap? I guess that depends on perspective. Are they cheap compared to six years ago? Yes? Compared to ten years ago? Maybe. Compared to fifteen years ago? Not as. Compared to the last one hundred years. Nope. The problem is that people develop these mindsets over periods of economic prosperity that are simply not sustainable. The trend never lasts forever. But, people say there is so much liquidity today or so much money chasing stocks or the world is a different place than fifty years ago. Maybe. But, do you realize that fifty years ago they were saying the same thing? That was their golden age of technology, economic growth, great wealth and enlightenment. One constant is human behavior. That never changes. And neither does the attempted rationalization as to why things are different this time. That is why the stock market never changes.

I've included a chart of stock market PEs for the last 140ish years. The chart is for the S&P 500, a broad measurement of 500 American companies. For those of you are are market neophytes, PE is the Price to Earnings ratio. A detailed explanation of what it is, how to use it and why it is important may be found at Investopedia, a wonderful investment education web site. Anyhow, the market PE as measured by the 500 companies in the S&P 500 today is about 17. Companies and financial firms are becoming crafty and there is more than one measurement of earnings. Operating earnings, GAAP earnings, earnings we want you to see, earnings that don't take into account options expensing and on and on and on. Gamesmanship. So is that cheap? Well, no it's not. It's above the historical average. Yet, looking at history, the markets don't tend to like averages. They are often well above average or well below average. This is true with returns as well. The historical average return for stocks, depending on how it is measured is approximately 7% over a long period of time. But, how many 7% years are there? Again, the markets don't seem to be conducive to the term average because returns are more likely to be 20% or -20% than 7%. Statistically, this means we have a very wide distribution of returns and averages aren't a good measurement of the data set. Ditto with PEs although they tend to be a little more stable in my opinion with the exception of times of irrational euphoria. So, let's look at a broader measure of the stock market. What's the PE of the Russell 2000, a measurement of 2000 companies on the stock exchanges? Well, last quarter, as I recall from memory, it was 38. Wow, 38. Do you want to pay for 38 years earnings to buy a stock? Does anyone know what the world will look like in 38 years? Do you know if a company will even be in existence in 38 years? Looking on the chart below, there's only one time in over one hundred years that the S&P PE was 38 or higher. When was that? That was in the bubble of 2000.

So, in the last four years, what has happened to the stock market PE ratio? It has contracted. Not only here but in nearly every major stock market around the world. When Wall Street is bullish about the future of the economy, stock market PEs around the globe expand along with earnings. The rationale for this is that people are much more confident about the future and are willing to pay a higher multiple for stocks so PE's expand along with earnings. This time earnings have expanded but PE ratios have contracted. Historically, this is a very ominous sign for stocks. It means investors are not confident about the future so they are willing to pay less for a stock.

So, is this cycle of growth in stock prices sustainable? Is the market cheap? Well, earnings are the most cyclical in the last fifty years. Now, what does that mean? That many of the company earnings propping up the stock market are highly cyclical or in simple english, their earnings are like a yo-yo. They go up alot then come down alot. Hence cyclical. So, now that they have gone up alot, what have they done historically? You may fill in the blank yourself.

So, if earnings start to decline, will the PE ratio be 38 on the Russell 2000 or 17 on the S&P 500? No, the PE will rise as earnings fall. Historically, whenever earnings fall and PEs rise because of that, stocks fall because they are overvalued. So, is the market cheap? Compared to 2000, it's very cheap. What's the old saying? Those who don't heed history are doomed to repeat it?