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PERFORMANCE ANNOUNCEMENT
As Of: May 28, 2003
In The Eye Of The Storm
The stock market is rising on the delusion of hope.
After three years of stock market declines, capped by another war with Iraq, threats from North Korea, and SARS, most people would like to believe the worst is behind us. In the absence of more bad news, the stock market wants to go up. Even in the face of bad news (such as sinking durable goods orders, rising unemployment, etc.) investors are so numb that, unless the news is truly cataclysmic, the relative calm is allowing the stock market to trend up. (The market has been moving up steadily since March.) But this is only the eye of the storm, a temporary calm. A failure to lock in some profits and brace for the tough times ahead could be very costly for the naive investor who is chasing the market to higher highs.
Buying select stocks in July or October 2002 was a value decision, but buying stocks now is largely a momentum game, which will end badly when everyone tries to run for the door at once. I say this because the average price/earnings ratio is too high for current economic conditions. Everyone is buying on hope - the hope that the economy will improve later this year. But this is only a hope, not a certainty; and the stock market has already priced in a better world. There has not been a P/E contraction appropriate to the current investment risk.
Earnings used to be important because they were the resource from which companies could pay dividends to shareholders. However, over the last twenty-five years, dividends have become increasingly less important to investors. Stocks used to be perceived as more risky than bonds, and dividend yields often exceeded U.S. Treasury rates. By 1984, the dividend yield on the Standard & Poor's 500 Composite Index had dropped to 4.50%. The payout dropped steadily every year thereafter to 1.14% in 1999. There are many reasons why dividend payout has dropped (including unfavorable tax treatment), but the result has been to shift the reason for stock ownership away from income toward an emphasis on growth in share price. Growth in share price is primarily dependent on growth in company earnings. Thus we have the price-earnings ratio (share price divided by annual earnings), a measure of how a stock should be priced in relation to its earnings.
Just as the dividend yield has experienced a multi-decade drop, the price-earnings ratio has experienced a multi-decade increase. During the late 1940's and during the 1974-1981 period, the P/E ratio was as low as 7. It was never higher than the low 20's. In 1984 the P/E ratio of the S&P 500 was 10.05. It increased steadily to the mid 20's by the early 1990's and to over 30 by the end of the 1990's. As we all know, the stock market soared during the last decade.
What most people are perhaps not aware of is that the increase in stock prices was due more to an expansion in P/E ratios than to an increase in corporate earnings. At a P/E ratio of 10, the S&P 500 should have hit a high of 537.30 in 2000. At a P/E ratio of 15, the index should have been at 805.95. The index actually reached 1527.46 giving it a P/E ratio of 28.42 (down from a year-end high of 32.57 in 1998).What is wrong with a high P/E ratio? Many analysts felt that a higher P/E ratio was justified because interest rates were declining during the 1980's and 1990's. There are numerous arguments to support higher stock prices when interest rates go down, but I suspect that the P/E expansion was heavily driven by hugely inflated earnings expectations (particularly in the technology sector). Earnings in the S&P 500 doubled during the seven to eight year period from 1986 to 1994, and they were on track to double again by 2002. This works out to a 9% to 11% year-over-year growth rate in earnings; but with its optimistic exuberance, the stock market pushed prices up by 20% to 30% per year. The difference between inflated expectations, as reflected in share price, versus actual earnings growth can be seen in the following chart.
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If the P/E ratio had held steady at any level, the market would have experienced excellent growth. But the added expansion of P/E ratios created stupendous growth. And then along came earnings disappointments. Prices dropped with a decrease in earnings, but the P/E ratio is still abnormally high.
In a period when earnings drop, a high P/E ratio is especially harmful. A simple way to look at a P/E ratio is to understand that a P/E of 10 means it will take ten years of a company's earnings to equal the price that is being paid for the company's stock. When Coca Cola had a P/E of 50, it meant that investors would have to wait 50 years for the company to earn back the value that investors were paying for its stock. Obviously investors don't want to wait 50 years or 30 years just to get their money back. The reason that an investor might be willing to pay for a stock with a high P/E ratio is because of an expectation that earnings will dramatically increase and the P/E ratio will therefore decrease. If an investor buys at a 30 P/E ratio and the stock actually grows earnings at 20% per year, the investor will earn back his investment in ten to eleven years instead of thirty years. A big problem develops when expectations are not met.
An investor who buys a stock with a P/E ratio of 10 and experiences a disappointing 5% growth in earnings instead of an expected 20% growth in earnings, will have his payback period stretched out from 6 years to a little over 9 years. Perhaps not a happy situation, but not a disaster. As you can see from the chart below, the investor who buys a stock with a 30 P/E ratio and experiences exactly the same disappointing lower growth in earnings will find that his payback period is stretched from more than 10 years to more than 18 years. This 80% increase in the payback period is unacceptable and the P/E ratio needs to drop substantially.
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Of course, initially, investors want to believe that the slowdown in earnings is just temporary, and dramatic earnings growth will continue. Once it is perceived that a high P/E is pricing in perfection compounded (and earnings are not living up to expectations), then the cost of dropping back to reality, plus adding a risk premium for uncertainty, necessitates a devastating contraction in P/E ratios. At a current P/E ratio of 34 for the S&P 500, the stock market has built in very high expectations (higher than the mid 1990's when we had strong earnings growth), and that leads to the conclusion that P/E ratios are likely to drop further and the Standard & Poor's 500 needs to go down further. There is of course the possibility that the market just flatlines until earnings can catch up. Whether it is another leg down in the market or a sideways correction from here, there is no reason to buy at today's prices. (If earnings are adjusted down for pension shortfalls and expensing of options, the picture looks much worse.)
Why are we in the eye of the storm, with more trouble ahead? The primary reason is that high earnings growth will not develop in the future to support today's high P/E ratios. The Federal Reserve has finally acknowledged the possibility of deflation and committed all of its resources to fight this unwanted possibility by lowering interest rates, buying longer maturity bonds, quietly accepting a devaluation of the dollar, and pumping up the money supply. If we do have a real deflation, that would not be good for a stock market with a high P/E ratio. However, since the FED has been so vocal in their resistance to deflation, I now think it is more likely we will go back to inflation; but it will be with a slow growth or no growth economy. This is known a stagflation, and that is not good for a stock market with a high P/E ratio. Any way that the numbers are pushed, I do not think it is realistic to believe that earnings can grow into the current market valuation. Right now there is too much money dissatisfied with low interest rates desperately seeking an alternative place to go. Real estate is not the answer, and the stock market is not the answer at today's prices. A lot of people are making bad decisions right now. The best decision is to be conservative and be patient. In the long run money is made by buying low and selling high. It is a fool's game to buy high and hope that you can sell even higher. (Want a clue? Why are we seeing an historically high ratio of insider selling right now?)