DEBUNKING THE MYTH OF THE “P/E RATIO”

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stock-exchange-738671_1280

Written By:  Avery B. Goodman

Summary

The Price/Earnings Ratio is touted as a means of predicting stock price movement.

The Price/Earnings Ratio Has No Value in Predicting Future Stock Movement.

A stock price crash may be coming but the currently inflated S&P 500 P/E Ratio is meaningless.

The price/earnings ratio, or “P/E ratio”, is the current price of one share divided by the earnings per share of the company. Over the years, a lot of financial advisors and market gurus have pointed to this number as a method by which to determine whether a company’s share price will rise or fall. Others look at the P/E ratio as a way to determine whether stock indexes are susceptible to a big downturn.

If the ratio is low, some claim that a company’s stock valuation is “safe” and share prices are likely to rise. In contrast, if the ratio is high, they say share prices are likely to fall. That seems simple and intuitively sound doesn’t it? A nice simple idea like that always excites people. Other gurus decided to expand on it. They applied the idea to the broad indexes of stocks, coming up with a P/E ratio for the broad stock market, most often using the S&P 500. According to them, if the ratio of the S&P 500 is “dangerously high”, stock prices are “susceptible to a bear market.” Conversely, when ratios are low, they believe that the market will rise.

Unfortunately, it isn’t true.

The interest rate manipulations of a central bank are far more important than any other factor in a myriad of ways, even beyond the subject of stocks and economics. When people asked me how I knew that Donald Trump would be the next U.S. President a week before the election, for example, I answered by writing an article, and explaining that my insight came purely from observing gold price manipulation. If you want to learn how this works, read the novel “The Synod”.

At any rate, I made offhand mention of the fact that the Obama administration has helped create the biggest financial bubble in history. It triggered an unhappy comment from a stock-loving reader, who assumed I was talking about an impending crash in stock prices. I was actually talking about the bond market, which has a value several orders of magnitude larger than the stock market.

However, his comment raised some issues that beg clarification. The commenter insisted that stocks cannot crash because the S&P 500’s current P/E ratio is not historically high. At slightly over 25 to 1, he is wrong. It is historically high. It is simply not inside astronomical territory. But, it is a bit on the high side. History tells us that crashes don’t need to be preceded by astronomical P/E ratios.

Thankfully, for current stock investors, generally speaking, P/E ratios don’t matter much to future bull or bear trends. The ratio is most useful for evaluating the ability of a company to pay a dividend and for nothing else. That doesn’t mean stocks aren’t about to crash. It simply means that a modestly high or low P/E ratio has no predictive ability, whatsoever, when it comes to the future of stock prices. It never has. Never once! Just the opposite!

For example, the decline in stock prices at the beginning of the so-called “Great Recession” began in Fall of 2007. The S&P 500 P/E ratio was only a bit over 19 to 1! By January 2009, one year and four months later, stocks declined a lot. In spite of that, the P/E ratio had still risen to about 71! That’s when the fastest decline began (between January and mid-March 2009).

The key point is that the 71 to 1 ratio in January 2009 was not a result of rising stock values. It occurred because most investors fell behind the curve. They hadn’t dumped stocks vigorously enough to force prices down all the way yet. Earnings had simply fallen faster than stock prices, but stock prices were already in a bear market!

When the dot.com bubble started to burst, back in March, 2000, the S&P 500’s P/E ratio was a bit over 28 to 1. By August 2003, in spite of stocks having dropped by a huge amount, the P/E ratio was still 26.57. Again, investors fell behind the price drop. Another classic example was at the beginning of the Great Depression of the 1930s. In the late 1920s, the Federal Reserve flooded dollars into the economy to assist the British central bank in managing a floundering post-war British pound. With a massive increase in the money supply, American business artificially boomed.

The so-called “Roaring 20s” were an era in which earnings and dividend payments increased quickly. Every investment seemed to pay off. Stock prices followed but not in excess of the rise in company earnings. Like today, people dreamed about getting rich quick trading stocks. Earnings were so good that by January 1929, the S&P 500 P/E ratio was only a bit under 17.76. That was in spite of skyrocketing stock prices.

By October, 1929, however, the P/E ratio still stood at 17.83. By February 1933, when stock prices had finally fallen to about 10% of their value in 1929, the S&P 500 P/E ratio was 14.88! Here is the bottom line… in spite of the 90% decline in stock prices, the P/E was not very different from when prices were 900% higher!

What does that tell you, my friends? Many may be wondering how this could be possible? Most of your adult life, or at least that part of it in which you’ve been listening to the propaganda from talking heads, University Professors, and business media writers, you’ve always been told that P/E ratios matter.

They do matter, just not to whether a stock is about to go up or down. They matter with respect to the ability of a company to pay you a certain level of dividends. With respect to everything else, forget all P/E ratios. In a perfect world conceived in unrealistic economic theory, the P/E ratio might matter. It just doesn’t matter in our world.

That’s because in a stable economy, earnings would be a measure of how well run a company is. But, we don’t have an economy like that. What we have are central banks who determine bull and bear markets, by flooding money in and out of financial markets. The efficiency of company management is a factor, but a small one, when you compare it to the overall financial conditions created by this central banking manipulative activity. That’s why, in our world, the P/E ratio has no predictive value.

In the real world, earnings react to the money supply just like stock prices. When the money supply goes up, and interest rates go down, earnings go up and so do stock prices. The situation ends up artificial and temporary but that is what happens. You can complain about it all you want. You should complain and try to change things. But, for now, it’s as simple as that.

That’s why P/E ratios cannot predict individual share prices in the future. It is also why they certainly cannot predict whether or not a bull or bear market is on the way. Remember, again, that the earnings of all companies ALWAYS go up when a central bank increases the money supply. That’s got nothing to do with the quality of the management team in any one company, or all the companies listed on the S&P 500 index.

The decisions of the central bank and the government are the primary things that determine whether stock prices crash or continue upward, but there are a few relevant questions you can ask. Once a lot of money has been printed, is the central bank going to significantly raise rates? Will they constrain liquidity? Will they narrow the loan windows from which banks can loan hedge funds and other speculators money? If so, there will be a crash.

How big the crash will be is determined by how big the preceding bubble was. But, if they never raise rates, constrain liquidity or close loan windows, the ultimate result will be a collapse of the currency itself. To keep a boom going you not only can’t significantly raise interest rates, but you’ve got to keep the money spigot open and flowing. The amount of time it takes to collapse is primarily determined by how clever and believable the countering propaganda is.

In practical terms, going forward, if the Federal Reserve allows interest rates to rise significantly, it won’t matter whether the S&P 500’s P/E ratio is high or low. Earnings will fall, and the P/E ratios will rise unless stock prices drop (which they will). The current P/E ratio will have nothing to do with that.

Don’t get me wrong. What I have just told you doesn’t mean stock prices are about to crash. It just means that you should not be relying on P/E ratio’s to determine whether there is “froth on the stock bubble”, as some pundits like to put it. Current P/E ratios have NO VALUE in predicting future P/E ratios and, therefore, no value in predicting price movement.

The fact that P/E ratios are not in the stratosphere, right now, will do nothing to stop or slow down a potential stock price crash. That’s why, in my opinion, the safest bet, right now, is not general stock investment at all, but rather precious metals and mining companies. I don’t come to this conclusion based on P/E ratios, but on the probability that the Federal Reserve will be raising interest rates, and the fact that there is an insufficient quantity of gold to supply the market, as explained in more detail here.

History tells us that it is more likely that stocks will decline if P/E ratios are astronomically high and prices have already been heading down. But, almost all major stock market crashes including the Crash of 1929, the dot.com Crash of 2000, and the “Great Recession Crash of 2007 – 09” BEGIN with very modest S&P 500 P/E ratios. Therefore, be careful to evaluate the future based based on what the central bank does, not on P/E ratios.

Appended, below, is a list of the S&P 500’s P/E ratio at all points discussed in this article.

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PRICE/EARNINGS RATIO OF THE S&P 500 INDEX STOCKS
(Source: Schiller, Robert “Irrational Exuberance”
http://amzn.to/2fQ4kOV)

Date                  Value

11-25-16              25.46  (estimate)

Oct 1, 2016          24.53

Sep 1, 2016         24.82

Aug 1, 2016         24.98

Jul 1, 2016            24.72

Jun 1, 2016          23.97

May 1, 2016        23.81

Apr 1, 2016          23.97

Mar 1, 2016         23.39

Feb 1, 2016         22.02

Jan 1, 2016          22.18

Dec 1, 2015         23.74

Nov 1, 2015         23.67

Oct 1, 2015          22.68

Sep 1, 2015         21.45

Aug 1, 2015         22.15

Jul 1, 2015            22.40

Jun 1, 2015          22.12

May 1, 2015        21.92

Apr 1, 2015          21.42

Mar 1, 2015         20.96

Feb 1, 2015         20.77

Jan 1, 2015          20.02

Dec 1, 2014         20.08

Nov 1, 2014         19.75

Oct 1, 2014          18.50

Sep 1, 2014         18.81

Aug 1, 2014         18.68

Jul 1, 2014            18.96

Jun 1, 2014          18.88

May 1, 2014        18.46

Apr 1, 2014          18.35

Mar 1, 2014         18.48

Feb 1, 2014         18.06

Jan 1, 2014          18.15

Dec 1, 2013         18.04

Nov 1, 2013         18.15

Oct 1, 2013          17.86

Sep 1, 2013         17.88

Aug 1, 2013         17.91

Jul 1, 2013            18.12

Jun 1, 2013          17.80

May 1, 2013        18.25

Apr 1, 2013          17.69

Mar 1, 2013         17.68

Feb 1, 2013         17.32

Jan 1, 2013          17.03

Dec 1, 2012         16.44

Nov 1, 2012         16.12

Oct 1, 2012          16.62

Sep 1, 2012         16.69

Aug 1, 2012         16.14

Jul 1, 2012            15.55

Jun 1, 2012          15.05

May 1, 2012        15.22

Apr 1, 2012          15.70

Mar 1, 2012         15.69

Feb 1, 2012         15.37

Jan 1, 2012          14.87

Dec 1, 2011         14.30

Nov 1, 2011         14.10

Oct 1, 2011          13.88

Sep 1, 2011         13.50

Aug 1, 2011         13.79

Jul 1, 2011            15.61

Jun 1, 2011          15.35

May 1, 2011        16.12

Apr 1, 2011          16.21

Mar 1, 2011         16.04

Feb 1, 2011         16.52

Jan 1, 2011          16.30

Dec 1, 2010         16.05

Nov 1, 2010         15.88

Oct 1, 2010          15.90

Sep 1, 2010         15.61

Aug 1, 2010         15.47

Jul 1, 2010            15.72

Jun 1, 2010          16.15

May 1, 2010        17.30

Apr 1, 2010          19.01

Mar 1, 2010         18.91

Feb 1, 2010         18.91

Jan 1, 2010          20.70

Dec 1, 2009         21.78

Nov 1, 2009         28.51

Oct 1, 2009          42.12

Sep 1, 2009         83.30

Aug 1, 2009         92.95

Jul 1, 2009            101.87

Jun 1, 2009          123.32

May 1, 2009        123.73

Apr 1, 2009          119.85

Mar 1, 2009         110.37

Feb 1, 2009         84.46

Jan 1, 2009          70.91

Dec 1, 2008         58.98

Nov 1, 2008         34.99

Oct 1, 2008          27.22

Sep 1, 2008         26.48

Aug 1, 2008         26.83

Jul 1, 2008            25.37

Jun 1, 2008          26.11

May 1, 2008        25.81

Apr 1, 2008          23.88

Mar 1, 2008         21.81

Feb 1, 2008         21.74

Jan 1, 2008          21.46

Dec 1, 2007         22.35

Nov 1, 2007         20.81

Oct 1, 2007          20.68

Sep 1, 2007         19.05

Aug 1, 2007         18.02

Jul 1, 2007            18.36

Jun 1, 2007          17.83

May 1, 2007        17.92

Apr 1, 2007          17.48

Mar 1, 2007         16.92

Feb 1, 2007         17.49

Jan 1, 2007          17.36

Dec 1, 2006         17.38

Nov 1, 2006         17.24

Oct 1, 2006          17.14

Sep 1, 2006         16.77

Aug 1, 2006         16.67

Jul 1, 2006            16.61

Jun 1, 2006          16.82

May 1, 2006        17.46

Apr 1, 2006          17.77

Mar 1, 2006         17.80

Feb 1, 2006         17.80

Jan 1, 2006          18.07

Dec 1, 2005         18.07

Nov 1, 2005         18.01

Oct 1, 2005          17.64

Sep 1, 2005         18.44

Aug 1, 2005         18.72

Jul 1, 2005            19.00

Jun 1, 2005          19.00

May 1, 2005        18.93

Apr 1, 2005          19.02

Mar 1, 2005         19.84

Feb 1, 2005         20.11

Jan 1, 2005          19.99

Dec 1, 2004         20.48

Nov 1, 2004         20.05

Oct 1, 2004          19.25

Sep 1, 2004         19.35

Aug 1, 2004         19.03

Jul 1, 2004            19.51

Jun 1, 2004          20.17

May 1, 2004        20.14

Apr 1, 2004          21.23

Mar 1, 2004         21.62

Feb 1, 2004         22.46

Jan 1, 2004          22.73

Dec 1, 2003         22.17

Nov 1, 2003         23.15

Oct 1, 2003          24.75

Sep 1, 2003         26.42

Aug 1, 2003         26.57

Jul 1, 2003            27.65

Jun 1, 2003          28.60

May 1, 2003        28.24

Apr 1, 2003          28.05

Mar 1, 2003         27.92

Feb 1, 2003         28.46

Jan 1, 2003          31.43

Dec 1, 2002         32.59

Nov 1, 2002         32.03

Oct 1, 2002          29.24

Sep 1, 2002         28.89

Aug 1, 2002         31.53

Jul 1, 2002            32.46

Jun 1, 2002          37.92

May 1, 2002        41.41

Apr 1, 2002          43.81

Mar 1, 2002         46.71

Feb 1, 2002         44.57

Jan 1, 2002          46.17

Dec 1, 2001         46.37

Nov 1, 2001         43.62

Oct 1, 2001          39.72

Sep 1, 2001         36.90

Aug 1, 2001         37.85

Jul 1, 2001            35.46

Jun 1, 2001          33.67

May 1, 2001        32.02

Apr 1, 2001          27.96

Mar 1, 2001         26.10

Feb 1, 2001         27.81

Jan 1, 2001          27.55

Dec 1, 2000         26.62

Nov 1, 2000         26.90

Oct 1, 2000          26.50

Sep 1, 2000         27.34

Aug 1, 2000         27.97

Jul 1, 2000            28.05

Jun 1, 2000          28.16

May 1, 2000        27.49

Apr 1, 2000          28.50

Mar 1, 2000         28.31

Feb 1, 2000         27.76

Jan 1, 2000          29.04

Dec 1, 1999         29.66

Nov 1, 1999         29.74

Oct 1, 1999          28.66

Sep 1, 1999         29.99

Aug 1, 1999         30.89

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GREAT DEPRESSION ERA STATISTICS

Feb 1, 1933

14.88

Jan 1, 1933          17.29

Dec 1, 1932         16.63

Nov 1, 1932         16.40

Oct 1, 1932          16.18

Sep 1, 1932         17.96

Aug 1, 1932         15.69

Jul 1, 1932            10.22

Jun 1, 1932          9.35

May 1, 1932        10.40

Apr 1, 1932          11.63

Mar 1, 1932         14.75

Feb 1, 1932         14.19

Jan 1, 1932          14.07

Dec 1, 1931         13.84

Nov 1, 1931         16.23

Oct 1, 1931          15.30

Sep 1, 1931         16.90

Aug 1, 1931         19.04

Jul 1, 1931            18.86

Jun 1, 1931          17.56

May 1, 1931        17.48

Apr 1, 1931          18.66

Mar 1, 1931         19.92

Feb 1, 1931         18.90

Jan 1, 1931          17.00

Dec 1, 1930         15.99

Nov 1, 1930         16.29

Oct 1, 1930          16.59

Sep 1, 1930         18.39

Aug 1, 1930         17.62

Jul 1, 1930            16.98

Jun 1, 1930          16.68

May 1, 1930        17.87

Apr 1, 1930          18.19

Mar 1, 1930         16.51

Feb 1, 1930         15.38

Jan 1, 1930          13.92

Dec 1, 1929         13.29

Nov 1, 1929         12.94

Oct 1, 1929          17.83

Sep 1, 1929         20.19

Aug 1, 1929         19.67

Jul 1, 1929            18.86

Jun 1, 1929          17.43

May 1, 1929        17.34

Apr 1, 1929          17.32

Mar 1, 1929         17.66

Feb 1, 1929         17.60

Jan 1, 1929          17.76

 


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2 thoughts on “DEBUNKING THE MYTH OF THE “P/E RATIO””

  1. It is frequently said that over time, stocks always outperform gold. I suspect that this is actually not true. Consider a hypothetical purchase of 100 different stocks in 1916 (a century ago) for the at that time equivalent amount of 100 ounces of gold. Assume that these stocks were bought and held with NO TRADING permitted for 100 years. The question is how much these stocks would be worth today. My suspicion is that this stock portfolio would be worth today less than 100 ounces of gold. I think that is a very important question which deserves to be investigated seriously. To the best of my knowledge, nobody has done this investigation yet.

    The usual stock market indices are not a true reflection of the performance of the stock market since their composition is changing constantly, effectively ignoring capital losses in the stock market. To reproduce the performance of a stock market index, investors would have to trade constantly, incurring further losses to trading costs and taxation. Constant trading is not a fair alternative to a buy and hold strategy in gold. The investment into stock market can only be compared with active trading in gold. That is a strategy employed by central banks which trade gold actively with the goal not to maximize gains but to maximize losses in gold investments in order to direct the flow of savings into the stock and bond market. So if the manipulation of the gold price by central banks can truly be predicted, then this offers a profit opportunity for those interested to play that game.

    1. I generally agree. Aside from the trading costs, each time you trade stocks, you pay capital gains tax (assuming you have a profit). In addition, ignoring for a moment the estate tax that applies to all assets, the gains on gold are tax-free from generation to generation, so long as it is not sold. As with all assets transferred at death, the tax basis rises for each generation, to whatever the gold was worth on the date of the prior owner’s death. On the other hand, there is the problem and cost of storage, and if storage is sloppy, the problem of theft. This is a problem that does not exist with stocks anymore.

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