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August 02, 2005

Bull and Bear Market Cycles

In my post dated 7/28/05, I stated, "The chances of someone getting to the 8% average on stocks right now is also low because we are starting from a period of historically high P/E ratios."

Wayne Jones, one of my readers, left the following in response:

I am not an expert, but I do know that there are a lot of flavors of P/E Ratios. What flavor are you citing, and could you give more specifics about the different flavors? Like some charts or tables that show P/E ratio histories of, say, S&P 500, etc?

In short, could you elaborate on that statement? I thought current P/E ratios were below historical norm. Thanks.

Wayne, I am so glad you asked. One of the best explanations I have seen of the inverse correlation between P/E ratios and market returns is done by Ed Easterling¹. That is the data I based my statement on.

Ed calculates the P/E using the methodology put forward by Robert Shiller² in "Irrational Exuberance." He uses the real (inflation corrected) S&P Composite Index divided by the ten year moving average of real earnings on the index. This price to earnings ratio is a measure of how expensive the market is relative to corporate profits.

In "Irrational Exuberance" Shiller says:

I use the ten year average of real earnings for the denominator, along lines proposed by Benjamin Graham and David Dodd in 1934. The ten year average smooths out such events as the temporary burst in earnings during World War II, or the frequent boosts and declines that we see due to the business cycle.

In an email, Ed Easterling indirectly comments on Wayne's point that there are many different flavors of P/E ratio and why he thought the current P/E was historically low:

Although 26 is higher than the values often reported (some are forward-looking, others use operating earnings, and yet others use current reported earnings), the other methods are rarely compared to a historical data set that is calculated using the same respective methodology—one of the most egregious is to use forward operating earnings and compare it to Shiller’s (and Crestmont’s) historical series.

That would certainly make the current P/E look historically low, which is a good thing if you are trying to sell stocks!

But back to the issue at hand … Wayne wants to know if I can point him to any charts or tables that show the historical P/E. Again I can. Go look at Ed Easterling's most excellent summary. You will see that we are not only at the high end of the range but you will also see the strong correlation between high P/E's and bear markets.

Ed breaks up the period 1901 to 2004 into nine bull and bear market cycles. He shows the bull market cycles are marked by P/E ratios that start low and trend toward historically high levels while inflation does just the opposite.

The bear market cycles are marked by just the opposite - high P/E's trending downward and low inflation moving up. At a current P/E of 26 and inflation at around 3%, the bias certainly seems to be towards very modest stock market returns, at best.

By now, I am quite sure a number of my workshop graduates are jumping up and down and flailing all around. "I thought you didn't believe in predicting!"

I am not predicting. But I do believe in preparing. That's the reason I invest the way that I do. I don't want to have to hope I am retiring at just the right time. I think hope is a bad investment strategy. I think the lesson here is this ... the conclusions of Ed Easterling, Robert Shiller, John Mauldin and others require us to ask ourselves, "What if?", and to plan accordingly.

So what about you? Are you going to be an ostrich or an owl. Are you going to stick your head in the sand and hope you don't run out of money before you run out of breath - or be ever vigilant? Leave your comments below.

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¹ Ed Easterling is the founder of Crestmont Research and author of "Unexpected Returns." He serves as a founding Board Member of the Texas Hedge Fund Association and as an adjunct faculty member with the Cox School of Business at Southern Methodist University where he developed the curriculum and teaches a course on Hedge Fund Investment Management to graduate business school students.  He co-authored chapters in another excellent book, “Bull’s Eye Investing” by John Mauldin. You can listen to my interviews of both John and Ed in our archives.

² Robert Shiller is the Stanley B. Resor Professor of Economics at Yale University and author of the best-selling book, "Irrational Exuberance" and "The New Financial Order: Risk in the 21st Century." You can also listen to my interview with Bob Shiller in our archives.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Posted by Kim Snider on August 02, 2005 | Permalink

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