This "Non-Traditional" Valuation Measure Carries 3 Messages About U.S. Stocks

Tyler Durden's picture

Submitted by F.F.Wiley of Cyniconomics blog,

[S]tock prices have risen pretty robustly. But I think that if you look at traditional valuation measures, the kind of things that we monitor, akin to price-equity ratios, you would not see stock prices in territory that suggests bubble-like conditions.


- Janet Yellen, responding to a question in November’s nomination hearing

We offered our take on stock valuation several times last year, while arguing that traditional price-to-earnings multiples (P/Es) are almost useless during periods of heavy policy stimulus. We’ll take a different direction here, by suggesting a “fix” for an entirely different problem with traditional P/Es. Our analysis reveals three messages about current stock prices.

We’ll start with 100+ years of traditional P/Es based on trailing 12 month earnings:

price to peak earnings 1

From this simple chart, analysts draw conclusions about whether valuation is high, low or neutral versus historic norms. One problem with that – and the motivation behind this post – is in the depiction of historic norms. Analysts typically weight periods of expanding earnings equally with periods of depressed earnings. But when earnings are depressed, P/Es tend to spike upwards as the earnings input to the denominator shrinks.

Unusual jumps in P/Es often occur in bear markets, as we saw during the Internet bust and again in the housing bust. In each of these instances, P/Es reached all-time highs despite the fact that stock prices were far below prior peaks. For example, when the S&P 500 plummeted below 700 in March 2009, P/Es climbed to a new record of 79, on their way to five consecutive months of over 100! (These results are cut off the chart for scaling purposes.)

Such distortions may make you wonder: Do P/Es during earnings recessions tell us anything at all about stock valuation?

Our answer is no.

As any Excel user who’s been foiled by a “#DIV/0” message knows, ratios demand careful attention when the denominator is volatile. In this case, a better approach is to divide equity prices by the highest earnings result from any prior 12 month period. (Dividing by trend earnings or 10 year average earnings is better still, but we’ll leave these methods for other posts.) This measure of “price-to-peak earnings” (P/PE) isn’t skewed by recessions because the denominator never falls.

Here’s the chart:

price to peak earnings 2

The last three data points (for October, November and December) are 18.2, 18.7 and 18.8. As of November, we reached a new high for the current bull market. What’s more, there are only nine comparable, historic episodes of P/PE climbing above 18.5 (as numbered on the chart). Combining these episodes with other statistics, we’ve identified three possible messages:

Message #1: Beware the bear (he’ll be here within a few months)

After five of the nine P/PE breaches of 18.5, a bear market began within the next three months (with four of the market peaks remarkably occurring in the very next month):

price to peak earnings 3

Message #2: Time to buy (earnings will bust through their prior peak)

In three other episodes, earnings were accelerating and still hadn’t reached the peak of the previous earnings cycle. Each time, the P/PE breach of 18.5 was followed by three consecutive years of double-digit earnings growth, with stock prices rising strongly but still lagging earnings:

price to peak earnings 4

Message #3: Bull to bubble (prices will leave earnings behind)

In the remaining episode (1996), earnings had already breached their prior cycle peak and would soon level off. The bigger story after this P/PE breach of 18.5 was the dizzying rise in stock prices that would outpace earnings by a large margin. Here are the details, along with a comparison to circumstances as of last month:

price to peak earnings 5

One way to interpret these results is to focus on the number of episodes linked to each of the three messages. That won’t be our approach.

We prefer to condition the results on two factors, one based on the earnings cycle and the other on the Fed. For the first factor, we look at whether earnings were accelerating upwards from below the prior cycle peak. For the second factor, we separate the Fed’s first eight decades (described according to the old-time philosophy of “taking away the punch bowl when the party gets going”) from the last two decades of Greenspan/Bernanke puts (based on the new philosophy of “refilling the punch bowl”).

price to peak earnings 6

As you might guess from the grid, we’re not convinced that current P/PEs signal a bear market in 2014, despite the facts that:

  1. Five of nine instances (56%) of P/PE breaching 18.5 were closely followed by market peaks.
  2. When earnings are at all-time highs, five of six instances (83%) of P/PE breaching 18.5 were closely followed by market peaks.

Not only do we have to be careful about using price multiples for forecasting (as mentioned in earlier posts), but we currently sit in the grid’s lower right-hand quadrant with the Fed setting new standards for short-term market support. The only other P/PE breach of 18.5 belonging to this quadrant was in the early stages of the Internet bubble.

What’s more, recent earnings and stock performance match up more closely with the Internet bubble episode – as shown in the “Message 3” table – than with the episodes in the “Message 2” table.

So, are we predicting four years of soaring stock prices and nonsensical valuations, as in 1996 to 2000?

Not exactly.

The past can offer clues to the future but it doesn’t give us a blueprint. The bigger message is that today’s valuations don’t bode well for long-term returns, where long-term means beyond the next market peak. Prices could surely bubble upwards from here, but bubbles are invariably followed by severe bear markets. (We’ll expand on this outlook in a future post, where we’ll add total return estimates.)

More importantly, we shouldn’t be fooled by traditional valuation measures. P/Es, in particular, have several flaws. We’ve shown in past articles that we get completely different results when we adjust earnings to account for mean reversion. We made a separate adjustment here to correct for the distorting effects of earnings recessions. Either way, our conclusions are a far cry from the “nothing to see here” that we keep hearing from the Fed.

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VD's picture

hey al i think i'm startin to peak now

The Mist's picture

One question only matters; will the 'economic recovery' hold.

If yes, BTFATH

If not, wait to BTFD

Raymond K Hessel's picture

Did I read it too fast or did he write that things are going in a certain unless they're not?   It's in my head now and I can't get it out.  Ow.


Me thinks someone spiked the punchbowl. You mean stock valuation isn't for real?                                                                                                                                                                                                                           /sarc

Stuck on Zero's picture

I prefer to think in terms of price to dividend ratio.  What good is a lot of earnings if you never get a dividend.  There are way to many stocks out there that have good earnings but nothing ever comes back to the shareholder.


Soul Glow's picture

Dividends wreck assets.  Just because a corporation gives a dividend does not make it a healthy stock.

The Mist's picture

Ummm, I don't know, maybe reinvestments in the company make the stock price go up?

JPM Hater001's picture

I'm thinking it's still got a long way to go...



Joenobody12's picture

What part of inflation does ZH not understand ? Stock price is high because the dollar is cheaper by the day. Simple as that. Adjust the stock price to 2019 dollar and it is CHEAP ! 

Sudden Debt's picture

but the definition of earnings has changed a lot!
coprorate takeovers with debt are also calculated in as earnings for the next 10 years where stock switches are made to create extra value that isn't there sometimes creating more value than the actuall worth of the company.

Believe me, I see that shit every day at work and it's a spiderweb of fraud.

formadesika3's picture

Can you explain that a little? What part of a takeover would be amortized as earnings?

If this really is a major change that affects major indexes, it would be useful to know about it. 

kevinearick's picture

boiling water...nothing changed, but the rigged numbers, nothing...

Property & Monetary Velocity

You are looking at a walk-out / lock-out, which begins and ends with marriage, because privacy and trust begin in the home, and no economy can generate profit without them. The public trust is a distant derivative. And the Fed just blew up the prevailing money mythology, leaving the property mythology exposed to direct global examination.

The latest and greatest divide-and-conquer empire ran its course a few generations ago, blowing up the gold standard and ushering in fiat liquidation, holding labor rates constant with free trade agreements and inflating property with synchronized global monetary policy. Gorbachev didn’t cause the collapse of Soviet communism, but the Chinese communists need to blame someone, for the only possible outcome of enforced urbanization.

Within an empire economy, women compete with men on the characteristic of stupidity, proliferating ignorance, measured as economic activity, in a competition to exploit all natural resources, including their own subgroups, down to the last child, creating tiles, called property, with peer pressure enforced urbanization to consolidate control. Those artificial borders cut off natural resources to ensure artificial scarcity, and may only be maintained by war.

Government may print with impunity only so long as it can get its participating population to chase money with time, to collect property. The problem solution is that momentum of majority behavior cannot be altered in real time. The Fed saw the participation rate, and inflated inventory, because it is a creature of peer pressure, like everything else in the empire.

Under globalization, children became the only net immigrants available for exploitation, and it took them a while to employ the conspiracy of stupidity against itself, instead of rebelling against it like their peers and wasting their time. The States can arbitrarily assign all the debt they want, and China can buy all the debt it likes, by issuing debt money for the purpose, and Obama can talk about equal rights to other people’s work all he likes, but none of them can make the pie they so greedily want to govern, to cut up for redistribution, keeping the biggest slice for themselves. Hillarycare is just another Roman Census.

The empire has now subjected itself to the greatest population deceleration since the Great Depression. San Jose, the Silicon Valley global exit strategy, is in trouble. Neither its stadium nor San Francisco’s subsidy of Twit will help, Bay Area Metro will be cutting hours and pensions like all the other municipalities, and rents relative to labor are going to fall.

The data, adjusted for civil marriage / Family Law, tells you that rents are relative to hours worked. The more hours empire participants work, the more rent goes up. When the bank talks about priming the pump, it is monetizing inventory to that end, which is why it loses financial control when participation declines. QEInfinity is a Hail Mary.

If you are working 60 hrs/wk at $10/hr, you don’t have time to find a part-time job at $25/hr, and you will soon be working 70 hrs/wk, chasing and falling further behind the real estate inflation welfare program. Cut out the middlemen between you and the land, and employ money to discount money from your life. If you employ your talent to build goodwill with others doing the same, monetary velocity collapses relative to you, and ultimately across the empire.

Real estate is a welfare program, paying people to live in a bubble, in fear of their neighbor, replacing real wealth with the illusion of wealth, the wealth effect, leaving no option but exploitation for the participants. Government is the least responsible landlord, because it is furthest behind in time. Change the Charter, issue money directly with a public bank, do whatever you want; adding another layer on the same foundation of sand will only accelerate the write-downs.

Housing is an equal right entitlement, which simply means that it is dependent upon peer pressure in a bankruptcy line. You have to earn a home. Don’t waste your time working for the empire. 24 hrs/wk is more than sufficient to pay for the recycled material.

For labor, economics is simple, the best use of resources for the labor community, which is small relative to the general population. Labor doesn’t need money; it makes the pie and the pie is money. The middle class is largely chasing peas in a shell game, different colored cars, and labor can ignore the property market, because the proprietors cannot effectively place land into production; they are too busy making land exclusive, artificially scarce.

Labor is the producer, keeping property in recursive leaseholds to filter out empire fiscal and monetary policy, which the empire can’t see until it has run its course. Labor teaches its own children, and sends them to school only to learn the M-P limits, to set their distance relative to their own interests. The People’s Republic of Communist California is welcome to issue as much debt as it wants, and to hold as many children hostage to the stupidity as it wants.

American exceptional-ism, like all the other isms, is failing. Whether you view the incidence as a threat or an opportunity depends upon your perspective, the location of your spirit. Find your spirit in the eyes of another and you will find your self. That is the light of liberty.


Yancey Ward's picture

Bullshit!  Corporate earnings are on a permanently higher plateau.

Spungo's picture

Guys, you're looking at this all wrong. The PE ratio might be 20 or 30 or whatever, but that's because earnings follow the price. First the price goes up for no reason, and then the earnings go up to match the price. This is how regression to the mean works. The earnings couldn't possibly go down, making the PE even worse than it currently is.

(a retard on youtube called StockTradingMaster actually said this in one of his videos)

Longing for the old America's picture

You can only know 'peak' earnings looking backwards.


This article is Peak BS.

Rising Sun's picture

if wealth is concentrated, as it is today, there are fewer consumers - trickles down to stalled/declining revenue


so we have cut our way to success - only works for so long


corps have been fucking with the S in EPS - making it smaller and issue near zero interest bonds in place of the market's benefits


this shit show is leveraged up by the quarter as the CXO's look for new ways to keep their jobs for another 90 days


leverage on the way up, deleverage on the way down


and if this was not the case, there would be no need for POMO - now $75B / month - fuck you Yellen, fuck you Barry