Flunking P.E. is pretty difficult to do. My wife almost accomplished the feat, but failed (or passed, depending on how you look at it) – a near-accomplishment which I still tease her about. Now in all fairness, my wife was struggling with undiagnosed mono at the time, making her continued absences suspect. But aside from unusual circumstances, P.E. is a cake walk: you show up, perform a few exercises (or at least have a reasonable excuse as to why you can’t), and leave. The only individuals who fail (usually) are those who don’t show up in the first place – or, as in the case of many investors today, those who show up at the wrong time.

 

The Problem of Price

Many investors don’t care about “P.E.”. But they should care about P/E, or the price-to-earnings ratio of company stocks. If for no other reason than it’s important to have an idea of what something is worth before you spend money on it.

If you take the current price of a stock, divide it by the earnings per share of the company, you get a company’s P/E. A lower P/E means the price of the stock is low compared to the value (i.e. earnings) of the company. This would indicate that a company is undervalued – a good buy! Likewise, a higher P/E means the price of the stock is high compared to the company’s earnings, or overvalued. If you take the average of those earnings over a 10-year period (adjust for inflation), you get the “CAPE P/E”, which is an even better gauge of price relative to value. Why? Because it smooths out irregularities in earnings that can occur over short periods of times.

What’s important to remember in all this is that price doesn’t always correlate with value. Sometimes, they are significantly different. Like when I accidentally bought fat-free hotdogs, sometimes we pay more than what something is worth. Conversely, sometimes we pay less. In all our various transactions, though, there is a quantifiable (albeit somewhat subjective) estimation of the value of the product which we are purchasing. At higher prices, we generally want less of something. At lower prices, we generally want more.

 

Are you flunking?

Today, many investors are flunking P.E. even though they are showing up. In fact, they are flunking because they are showing up – at just the wrong time.

Historically, investors have considered a P/E of 15 to be a fair price for stocks. A P/E of 20 would indicate the price is high compared to the value, and less would be demanded. Conversely, a P/E of 10 would be considered a low price and more would be demanded. There is a certain equilibrium that occurs to bring this metric, over time, back to the mean. At lower prices, people typically want more stocks, bringing the P/E back towards 15. Likewise, at higher prices, typically people want less, providing downward pressure to bring the P/E back to 15.

Today, the CAPE P/E of the S&P 500 has just recently crested 29. Yes, 29! That is, the S&P 500 is priced at nearly twice it’s “fair value”. To provide a little perspective, this height in the P/E metric has only been eclipsed two other times: at the start of the Great Depression, and right before the Dot.com bubble. From a historical perspective, there isn’t a lot of guesswork required to see what comes next:

Source: http://www.multpl.com/shiller-pe/

Although a reversion to the mean is to be expected, investors are still showing up to drive the P/E higher. And they are showing up at the worst possible time.

Towards the end of last year, money was flowing into U.S. equities at a record pace, with investors salivating over the prospect of a pro-business presidency. Through the first quarter of 2017, the inflows have slowed but continue to push the market higher. In other words, investors are still buying US equities. It seems that the higher the prices go the more investors want to buy them.

 

Current Price & Future Returns

For many investors, past returns are all that matter. If U.S. company stocks have done well in the recent past, then they are a good buy. Conversely, many investors think that if an investment has done poorly recently, it must be time to sell. But a declining price doesn’t necessarily make an investment bad. Neither does a rising price make an investment good. This type of thinking actually turns investing on its head, as if to suggest that buying high and selling low is the way to make money.

This also misses the broader relationship between current price and future returns. Every investment is a claim on future cash flows, or returns.  It follows that the higher the price you pay now, the lower your expected returns should be going forward. The cash flows, you see, don’t just magically increase or decrease based on your purchase price. Rather, the price is supposed to reflect the increase or decrease in the expected cash flows. Higher cash flows imply greater company value, and therefore a higher stock price. And vice versa. The important thing to notice right now is the vice versa.

The great irony of today’s bull-market is that while earnings have mostly declined since 2013, the price (as measured by the P/E) for owning these companies has increased dramatically – from 21 in January 2013 to over 29 today. As a result, the expected 10-12 year returns of the S&P 500 are nowhere near their historical average of 8-10%. Rather, at today’s prices, the next decade should see returns of less than 1%. Whatever term you wish to use to describe today’s continued bull-market, sound investing shouldn’t be one of them.

 

Repeating the course

It certainly is difficult to flunk P.E. What might be harder is having to retake it. We have seen P/E ratios this high before, and over the completion of every market cycle in history the ratio has reverted to close to – or under – the mean of 15-16. In order for that to happen today, one of two things must happen: either we face an unprecedented boom in company earnings, or, as is far more likely, a drop of 40-50% in the price of the S&P 500.

As obvious as this is, many investors won’t change. It’ feels right to continue the course as stocks continue higher. Likewise, it only feels right to sell investments after they lose a considerable amount of their value. And so many investors (and that includes most advisors) won’t make changes until the market is already tanking.

But as professional portfolio managers, it’s our job to help our client’s navigate the markets effectively and efficiently. For this reason, over the past few years we have been selling out of U.S. stocks while the prices are high. What have we done with the proceeds? We have bought internationally, where most everything is undervalued. Many emerging markets are undervalued, with P/E ratios around 10-12. It might be time to ask yourself: do you know where your stocks are?

 

Conclusion

At Plan Financial we care about accomplishing our client’s long-term objectives, whatever that may be. In order to successfully navigate the ever-changing conditions and the onslaught of (fake) news, we have developed and maintained a disciplined investment process. This process has proven successful time and again. While focusing on economic fundamentals, we certainly aren’t “fuddy duddies”. Our approach to investing is informed by the latest developments in the markets and the global economy. However, we do maintain a commitment to certain timeless principles which provide the backbone to our portfolios and, subsequently, to our client’s success. If you’d like to learn more, give us a call!

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