Excessive Worth/Earnings Ratios and the Inventory Market: a Private Odyssey

After some forty years of banking and investments, I retired in 2001. However since I don’t golf, I quickly discovered retirement to be very boring. So I made a decision to return to the funding world after ten months. Nevertheless, these ten months weren’t a whole waste of time, for I had spent them in attempting to make the most of my forty years of funding expertise to achieve perspective on the newest inventory market “bubble” and subsequent “crash.”

There have been a number of individuals who noticed the inventory market crash coming, however they’d totally different concepts as to when it will happen. Those that have been too early needed to undergo the derision of their friends. It was troublesome to take a stand when so many have been proclaiming that we have been in a “new period” of investing and that the previous guidelines now not utilized. For the reason that starting of 1998 via the market excessive of March 2000, amongst 8,000 inventory suggestions by Wall Avenue analysts, solely 29 beneficial
“promote.”

I’m on file as having referred to as for a cautious strategy to funding two years earlier than the “Crash of 2000.” In an in-house funding e-newsletter dated April 1998, I’ve an image of the “Titanic” with the caption: “Does anybody see any icebergs?”

Once I resumed employment in 2002, I occurred to look on the chart on the final web page of Worth Line, which confirmed the inventory market as having topped out, by coincidence, in April 1998, the identical date as my “Titanic” e-newsletter! The Worth Line Composite Index reached a excessive of 508.39 on April 21, 1998 and has been decrease EVER SINCE! However on the primary web page of the identical concern, the date of the market excessive was given as “5-22-01”! Once I contacted Worth Line about this discrepancy , I used to be shocked to study that they’d modified their methodology of computing the index for “market highs” from “geometric” to “arithmetic.” They stated they might change the identify of the Worth Line “Composite” Index to the Worth Line “Geometric” Index, since that’s the way it has been computed through the years. Presently Worth Line is displaying a latest market low on 10-9-02 and the newest market excessive, based mostly on this new “arithmetic” index, on 4-5-04, ANOTHER ALL-TIME HIGH! If they’d stayed with the unique “geometric” index, the all-time excessive would nonetheless be April 21, 1998!

Later that yr, I used to be pleasantly shocked to learn in “Barron’s” an interview with Ned Davis, of Ned Davis Analysis, that stated that his indicators had picked up on the bear market’s beginnings in April 1998, the identical date as my “Titanic” e-newsletter! So, my instincts have been right! I consider that we’re in a “secular” downturn that started in April 1998 and the “Bubble of 2000” was a market rally in what was already a long-term bear market.

One other improvement transpired quickly after I resumed employment in 2002. I occurred to note someday that, in its “Market Laboratory,” “Barron’s” had inexplicably modified the P/E Ratio of the S&P 500 to twenty-eight.57 from 40.03 the earlier week! This was attributable to a change to “working” earnings of $39.28 from “web” or “reported ” earnings of $28.31 the earlier week. I and others wrote to “Barron’s Mailbag” to complain about this transformation and to disagree with it, since these new P/E ratios couldn’t be in contrast with historic P/Es. “Barron’s apparently accepted our arguments and, about two months later, modified again to utilizing “reported” earnings as an alternative of “working” earnings and revised the S&P 500 knowledge to point out a P/E Ratio of 45.09 in comparison with a earlier week’s 29.64.

However an analogous drawback occurred the subsequent day in a sister publication to “Barron’s.” On April 9, 2002, “The Wall Avenue Journal” got here out with a brand new format that included, for the primary time, charts and knowledge for the Nasdaq Composite, S&P 500 Index and Russell 2000, along with its personal three Dow Jones indices. The P/E Ratio for the S&P 500 was given as 26, as an alternative of the 45.09 now present in “Barron’s.” I wrote to the WSJ and after a lot correspondence backwards and forwards, they lastly accepted my argument and on July 29, 2002 modified the P/E Ratio for the S&P 500 from 19 to 30! I had given them examples displaying the place some monetary writers had inadvertently confused “apples” with “oranges” by evaluating their P/E of 19, based mostly on “working” earnings, with the long-term common P/E of 16, based mostly on “reported” earnings.

As a result of I began to be cautious about investing as early as April 1998, since I assumed that value/earnings ratios for the inventory market have been perilously excessive, I used to be not harm personally by the “Crash of 2000” and had tried to get my shoppers into much less aggressive and extra liquid positions of their funding portfolios. However the pressures to associate with the market have been large!

Worth/earnings ratios don’t allow us to “time the market.” However evaluating them to previous historic efficiency does allow us to inform when a inventory market is excessive and weak to eventual correction, despite the fact that others round us could have misplaced their bearings. Excessive P/Es alert us to a necessity for warning and a conservative strategy in our funding selections, corresponding to a renewed emphasis on dividends. Very excessive P/Es normally point out a long-term bear market could ensue for a really lengthy time period. We’re apparently in such a long-term bear market now. However in figuring out whether or not the market is excessive, we have to be vigilant with regard to what knowledge mambers of the monetary press are reporting to us, so we will evaluate “apples” with “apples.” When the monetary info doesn’t seem like right, we, as monetary analysts, owe it to the funding group to problem such info. That’s what I’ve concluded from my private “odyssey” within the funding world.

After three years of the DJIA and the S&P 500 closing beneath their earlier year-end figures, the market lastly closed larger on the finish of 2003. However the P/E ratio remains to be excessive for each indices.

Does anybody see any icebergs?