P/E Ratios as a Buy Signal?

Sunday, December 10, 2006 | 08:01 AM

I get all sorts of email. Some of it, I simply do not know what to do with. I respond to polite requests, I look at suggested specific links. Some I simply delete.

Then there's this sort of thing: I never know what to do with half formed concepts or unsupported arguments. These tend to raise more questions than they answer.

Consider the following interesting analysis (I responded to the author, but never heard back from them).

Based on this week's Chart of the Day, this person concluded:

"Wall Street uses 12-month forward EPS estimates to calculate P/E ratios.  The chart below is based on 12-month trailing EPS, which inflates the P/E ratio. Based on 12-month forward EPS, the post-WW II P/E ratio range for the S&P 500 Index has been 10x to 20x, excluding the 1970s nadir ~8x and the 1996-2000 bubble range of 20x to 26x. 

Regardless of the EPS figure used, the chart’s message is clear:  today’s P/E ratio is NOT excessive…based on 1980-2006 performance, it is about average with plenty of “head room” for P/E expansion.

Also, the “steep downtrend” between the dashed red & green parallel lines in chart below counts as five Elliott Waves down…followed by a turn UP.  THAT is extremely BULLish !!!  Suggests the potential for P/E ratio expansion for years to come…..that would fuel an incredible BULL market.



I find this sort of thing quite intriguing. The letter touches upon some fascinating points -- issues I am very interested in. But it fails to esolve them satisfactorily. Indeed, it raises more questions than it answers.

Here's the first dozen or so that popped into my head:

1. Why does a trailing P/E (price/actual earnings) "inflate the P/E ratio?"  Isn't genuine data -- what the earnings actually were, rather than what they were forecast to be -- more reliable than analyst consensus of earnings?

2. Do P/E ratios have any predictive power in forecasting the stock market's subsequent returns? What is the basis for that belief?  What specific P/E ratios have historically triggered a buy decision with a demonstrated ability of out-performance in the past?

3. The 1980-2006 period includes the longest bull market on record (1982-2000), thus skewing the P/E ratio upwards. How does the P/E look for full period 1950-2006 (inclusive of highs and lows)? What does the 1906-2006 range reveal? How about 1966-1982?   

4. Why do you think the market was in a bubble from 1996-2000? Wouldn't late 1999 to 2000 be a more accurate range for the tech bubble?

5. What is your basis for saying the dashed line is an Elliot 5 count? If it is, what is the historical forecasting record of using Elliot Wave 5 counts of P/Es as a buy indicator?

6. What has past P/E compression and expansion cycles looked like? Is this one similar or different to prior oscillations? Why?

7. "NOT excessive P/Es" (emailer's phrase) -- what are they?  What does that mean for subsequent market performance? Are "NOT excessive" P/Es a sufficient basis for making an investment decision?  Is additional confirmation needed for a buy or sell signal?

8. Forward P/Es are consensus opinions. How accurate have they been at major turning points (tops and bottoms)?

9. In 1999 and 2000, the S&P500 P/E ranged from 25-30; Why did it shoot up to 50 two years after the bubble popped? 

10. Is this actually a trailing P/E? (The chart is silent on this)

11. The 1982 Bull Market began at a P/E of 7. Will the next Bull market start from a higher, lower or the same P/E? Why?

12. That's a very awkwardly drawn channel, quite narrow, and intersecting the prior channel. What if I drew the channel differently? See below for a valid trend channnel.Pe_channel

Does that change your view of the "headroom?



About this original email: The idea behind this exercise isn't to say the the original emailer was wrong. For all we know, the author may be absolutely correct about their forecasted "Incredible Bull market."

But how can we tell? Lots of conclusions and unsupported assertions are built in --  highly subjective -- but there was no persuasive proof. These various questions point to that.

One of the reasons I have long been a fan of quantititative, technical and cycle based analysis is the ability to make an objective -- rather than a subjective, squishy analysis. That's been a big problem with much of what passes for pattern based technicals, too. 

That's also the reason I recommended David R. Aronson's tome, Evidence-Based Technical Analysis. I very much like the idea of applying a more rigorous scientific method of statistical analysis in generating less subjective trading signals.

Sunday, December 10, 2006 | 08:01 AM | Permalink | Comments (46) | TrackBack (0)
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You really took that one apart Barry. I was actually looking at some charts of similar precepts.
I have a chart saved on my computer from Decisionpoint.com although I couldn't find it on their site.

Looking over a much broader scale historical P/Es for the S&P more or less fell between the 10-20 range. Minyanville was more like 10-22.

Even so there were many a time that the P/E hit a low of nearly 10 times earnings (and after a heavy blow) while the market nevertheless dragged the bear on for sometimes 6-8 years following.

Following 1929 PE of 10 - to 5 - to 10 - back to 5.

Between 1964-80 the ratio pushed about 13 three times before diving below 10.

In 1987 the market retreated after hitting a ratio of 20 and didn't return till 1998.

Posted by: my1ambition | Dec 10, 2006 9:12:03 AM

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