Lots of analysts are shouting that stocks are undervalued because next year’s earnings are only down 25% while the stock prices are down 50%. They claim this means the equities are a buy. They’re ignoring the important question of how much we should pay for those earnings.
Here’s a graph of the historical PE (price to earnings) ratio of US equities over the last 100 years. The PE ratio is what investors were willing to pay for a company relative to the previous year’s earnings. A lot of things affect what investors are willing to pay including interest rates, the opportunity cost of their money, expected inflation, and their general tolerance for risk.
Most textbooks teach that rational investors use the “risk-free rate”, basically US treasuries, as their benchmark when deciding whether to invest in equities. The theory goes that investors compare the future returns on equities to treasuries, and will hold equities if the excess returns are high enough to justify the risk. I think this is a silly way of thinking about it. We have only a guess as to what future returns will be, and more importantly, we have no idea how future returns connect to current prices. The academic model suggests that with the S&P 500 index at 1100 I might be unwilling to invest in equities because the equity premium is too small, but with the index at 1000, I would throw my money into equities since my expected returns are now greater. In reality, as the market drops from 1100 to 1000, I have no reason to think that equities are now a better investment. Perhaps the market is being efficient and correctly pricing in new bad information. Moreover, most investors will reasonably grow more risk averse because their real wealth has decreased and volatility (risk) has probably increased.
So what is a fair PE ratio today? Since the wealth of the world (and of most investors) has plummeted, PEs should be low. We are all more risk averse when our nest eggs (or tier 1 capital) has eroded. Low interest rates would normally justify higher PE ratios since the opportunity cost of money would be low, but today’s interest rates are deceiving; while the treasury and interbank rates are low, companies and individuals can’t actually borrow at those rates. Low interest rates also justify higher PEs because they increase the present value of future corporate earnings, but again this is deceiving; a lot of investors (myself included) believe that the low interest rates on government debt are crowding out private borrowing and thus reducing future growth prospects. Using historical data as a rough guide, we can expect PEs in the 10-16 range over the next few years. However, a bad recession frequently sends PEs below 8 for a brief period, so we need to be prepared for that possibility. If inflation expectations become severe, we can expect lower PEs for longer as investors require higher rates of nominal returns to make up for the erosion caused by inflation.
Next time you hear someone say that a stock is cheap relative to its earnings, ask what those earnings are worth. Even if corporate earnings were completely unchanged, a rational drop in the risk appetite of investors or a rise in inflation could justify a 50% drop in share prices.
Originally published at Risk Over Reward blog and reproduced here with the author’s permission.