One More Dubious Assumption

While reality-based analysts focus on the negative implications for Wall Street and Main Street of a growing global credit crunch, the rose-colored glasses set keeps looking the other way.

In their view, it's all just a flash in the pan. With the Federal Reserve and other central banks stepping in to ease supposedly short-term liquidity concerns, and the global economy apparently humming along nicely, they are confident the turmoil of recent weeks will turn out to be yet another buying opportunity.

One plank the permabulls keep resting their optimism on is the notion that stocks are "cheap," and that those who view themselves as connoisseurs of value would be foolish to skip all the bargains on offer. In making that claim, many rely on yardsticks that have allegedly passed muster with the experts, as well as the test of time.

Unfortunately, that may not necessarily be the case, as the International Herald Tribune's David Leonhardt notes in "What Most Investors Don't Know About Price Earnings Ratios."

More than 70 years ago, two Columbia University professors named Benjamin Graham and David Dodd came up with a simple investing idea that remains more influential than perhaps any other.

After the 1929 stock market crash, they urged investors to focus on hard facts - like a company's past earnings and the value of its assets - rather than trying to guess what the future would bring. A company with strong profits and a relatively low stock price was probably undervalued, according to Graham and Dodd.

Their classic 1934 textbook, "Security Analysis," became the bible for what is now known as value investing. Warren Buffett took Graham's course at Columbia Business School in the 1950s and, after working briefly for Graham's investment firm, set out on his own to successfully put the theories into practice.

Yet, somehow, one of their big ideas about how to analyze stock prices has been almost entirely forgotten. The idea essentially reminds investors to focus on long-term trends and not to get caught up in the moment.

Amid the recent market turmoil, most Wall Street analysts, of course, say that there is nothing to be worried about, at least not in the broader stock market. In an effort to calm investors, analysts have been arguing that stocks are not expensive now. The basis for this argument is the standard measure of the market: the price/earnings ratio.

It sounds like just the sort of thing Graham and Dodd would have loved. In its most common form, the ratio is equal to a company's stock price divided by its earnings per share over the past 12 months. You can skip the math, though, and simply remember that a P/E ratio tells you how much a stock costs relative to a company's performance. The higher the ratio, the more expensive the stock is - and the stronger the argument that it won't do very well going forward.

Now, the stocks in the Standard & Poor's 500 have an average P/E ratio of about 16.8, which by historical standards is normal. Since World War II, the average ratio has been 16.1. During the bubbles of the 1920s and the 1990s, the ratio shot above 30.

The core of Wall Street's reassuring message, then, is that even if the current mortgage mess leads to a full-blown credit crunch, the damage will not last long because stocks don't have far to fall.

As it happens, Graham and Dodd did put a lot of faith in ratios, but they would have taken issue with the way that the number is used today. Besides advising investors to focus on the past, the two men also cautioned against putting too much emphasis on the very recent past. To their thinking, a few months, or even a year's, worth of financial information could be deeply misleading. It could say more about what the economy happened to be doing at any one moment than about a company's long-term prospects.

So Graham and Dodd argued that P/E ratios should compare stock prices to "not less than five years, preferably seven or ten years" of profits.

This advice has been largely lost to history. For one thing, collecting a decade's worth of earnings data can be time consuming. It also seems a little strange to look so far into the past when your goal is to predict the future.

But at least one economist has remembered the advice. For years, Robert Shiller, a professor at Yale, has been calculating long-term P/E ratios. And when he was invited to a make a presentation to Alan Greenspan in 1996, Shiller used the statistic to argue that stocks were badly overvalued. A few days later, Greenspan sparked a brief worldwide sell-off by wondering aloud whether "irrational exuberance" was infecting the markets.

Today, the Graham-Dodd approach produces a very different picture from the one that Wall Street has been offering. Based on average profits over the past 10 years, the P/E ratio has been hovering around 27 recently. That's higher than it has been at any other point during the past 130 years, except for the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.

This one statistic does not mean that a bear market is inevitable. But it does offer a good framework for thinking about stocks.

In the past few years, corporate profits have soared. Economies around the world have been growing, new technologies have made companies more efficient and for a variety of reasons - globalization and automation chief among them - workers have not been able to demand big pay increases. In just three years, from 2003 to 2006, inflation-adjusted corporate profits jumped more than 30 percent, according to the Commerce Department. This boom has allowed standard P/E ratios to remain fairly low.

Going forward, one possibility is that the boom continues. In this case, the Graham-Dodd P/E ratio does not really matter. It is capturing a reality that no longer exists, and stocks could do very well during the next few years.

The other possibility is that the profit boom will prove to be fleeting. Perhaps the recent productivity gains will peter out, as some measures suggest is already happening. Or perhaps the world's major economies will slump in the next few years. If something along these lines happens, stocks may suddenly start to look very expensive.

In the long term, the stock market will almost certainly continue to be a good investment. But the next few years do seem to depend on a more rickety foundation than Wall Street's soothing words suggest.

Investors are banking on the idea that the economy has entered a new era of rapid profit growth, and most of the time, investments that depend on the words "new era" do not do so well. It is one more risk in a market that is relearning the meaning of the word.

Stay tuned for tomorrrow's lesson.

Comments

[Bill]

Latest headline at MSN says "Data Suggests economy is sound". I didn't need the data. Bush told me everything was fine and he's never wrong! Ok, he's made a mistake or two. But, Friedman couldn't be wrong.

Trade deficits are good, just look at employment and GDP. Please ignore the amount of debt we are racking up and our future liabilities. We can just print more money when we need it. We'll use our charm to convince the global marketplace to continue buying up something of declining value.

[Sackerson]

Thank you Michael, a useful addition, which gives more weight to Marc Faber's recent comments that there is an "earnings bubble" that has skewed p/e ratios and that he expects "earnings disappointments".