Money Matters: With investments, mind your P/E and Qs

By David Peartree The Daily Record Newswire I have proposed an investment dashboard -- a set of indicators to help investors manage their money and their emotions. Here we take a look at two indicators relating to equity market valuation and growth. 1: Market Valuation. What could be more important to the equity investor than knowing the value of the equity market? Who buys a house, other real estate, or a business without having at least some estimate of its fair value? Value is an important consideration, especially for the investor adding new dollars to a portfolio or considering a major portfolio shift. The key assumption here is that value and price can diverge. Not everyone believes that they do. Some economists espouse a theory known as the "efficient market hypothesis," which holds that markets are efficient and, therefore, are at all times fairly priced. The theory contains helpful insights about how markets work and my brief reference here does not do it justice. On balance, however, market history and investor behavior suggest otherwise. Value and price can and often do diverge. Valuation matters because it has a direct impact on the investor's prospects for long-term returns. If an investor buys when the market is reasonably valued, the prospects for decent long-term returns are enhanced. If an investor buys when the market is overpriced, however, the prospects for long-term returns are diminished and sometimes crushed. P/E ratios in various forms are commonly used to value the market. The Shiller P/E ratio, devised by Yale professor Robert Shiller, has been a remarkably accurate indicator of long-term (i.e. 10-year) returns. The Shiller P/E ratio divides the current price of the S&P 500 Index by the average inflation-adjusted earnings for the past 10 years. Right now, the Shiller P/E ratio is quite high. It is nearly 24, whereas the long-term average is around 15. What does that tell us? Very little about short-term returns; over the short term, returns can be strong even with elevated values. However, the data suggest that in the past when the P/E ratio has been elevated such as it is today, the average 10-year return of the S&P 500 Index has tended to be mediocre at best. Returns in the low- to mid-single digits have been the norm. The Q ratio is another valuation method worth paying attention to. It, too, is quite elevated. This method was devised by James Tobin, another Yale professor and Nobel laureate in economics, and calculates the current market price divided by the replacement cost of all its companies. These indicators do not issue ironclad predictions, but they are more than food for thought. The more you overpay, the harder it is to generate satisfactory long-term returns. For some historical context, John Hussman, an economist and lead manager at Hussman Funds, pointed out in February that "valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000." Enough said. 2: Corporate Earnings. Corporate earnings are interesting because they are one of the few closely followed GDP components from the income side of the ledger. Most of the GDP components tracked by economists and reported by the press are on the expense side. Consumer spending, private investment spending, government spending and other expenditures are believed to offer a reasonably accurate picture of the economy. Spending is hard to fudge. Income, on the other hand, is very malleable, subject to write-downs, write-offs and misstatements. It is harder to pin down to firm numbers. Even so, corporate earnings command attention because they are a key driver of market growth. Earnings are also one of the two plugged into the P/E ratio and, therefore, a significant factor in market valuation. A growth cycle in the economy generally starts with a rise in corporate earnings. Since World War II, earnings have grown at an annual rate of about 6 percent, roughly in line with economic growth. Over the past year, earnings have risen at the fastest rate in decades. Corporate profits and profit margins have approached record highs and both are well above their historical averages. This performance has helped propel the markets. The trend in earnings is an important driver of market growth. If earnings can maintain the current trend line, that would bode well for the markets. Alas, reversion to the mean is a powerful force in finance. A shift toward the historical norm would present a headwind for the markets. As an investor, what can you do with this information? First, it can help govern your expectations. Understanding market valuation and the importance of corporate earnings can help you maintain realistic expectations about the market and your own investment performance. It should keep you rooted in an appropriate allocation strategy. Second, market valuation can serve as an affirmation or as fair warning. Buying into a fairly priced market is an investment. Buying into an overpriced market begins to look like speculation. Market valuation and corporate earnings belong on the long-term investor's dashboard. ---------- David Peartree, JD, CFP is an investment advisor with Ciccarelli Advisory Services, a registered investment advisor, offering fee-based investment management and financial advice to individuals and families. He can be reached at dpeartree@fscadvisors.com. Published: Tue, Apr 26, 2011