On Advice

Is it time to rethink the price-earnings ratio?

Investment strategist: Common measure of long-term stock performance could be due for a rethink

Dec 12, 2013 @ 11:39 am

By Bruce Kelly

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Prudent financial advisers shudder when stock market pundits chatter about discovering new paradigms for measuring stocks, particularly during the heady days of a bull market — for good reason.

Such prattle about “paradigm shifts” in the broad stock market frequently spells calamity for advisers and their clients.

In the late 1990s, sell-side technology stock analysts said that investors could ignore the absence of earnings at white-hot tech startups because technology was a new paradigm, and what mattered was growth, not profits. But then in 2000, the Internet stock tech bubble burst bringing to a swift end a 10-year rally of 417% in the S&P 500.

Talking heads were buzzing about another “paradigm shift” a few years later, when many self-proclaimed savvy professional investors foretold that real estate values could only go up. Banks were enjoying record profits as mortgage refinancing boomed.

But in October 2007, the housing bubble burst after the S&P 500 had clocked a 101% increase over the previous five years.

This bull market, which started in March 2009, has seen the S&P 500 advance 138%. Such a dramatic increase in the broad market, particularly after the Great Recession, has many advisers and market commentators wondering whether stock prices are about to collapse.

One market strategist, however, has started to question whether a true paradigm shift has occurred in common valuation levels for the broad market.

This time, however, it is a paradigm shift that advisers ought to consider, if only to challenge their own assumptions about stock market valuations and whether they are about to tank or will continue to move upward.

In a note to investors this month titled, “A New Valuation Range for the Stock Market?” James Paulsen of Wells Capital Management Inc., which manages $316.6 billion, asked whether it is time for investors to shift their historic perceptions of the potential long-term performance of stocks in light of the past 25 years of performance.

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Mr. Paulsen, the firm's chief investment strategist, has put under the microscope one of the most revered — and accurate — historic metrics to discern whether the stock market is fairly valued: the tried-and-true price-earnings ratio, based on the trailing 12 months' earnings per share.

That measure is the prior-12-month valuation ratio of the companies in a stock market index such as the S&P 500 and their collective current share prices, compared with their per-share earnings.

The gist of Mr. Paulsen's argument is that, for the past 25 years, the U.S. market has remained above its historic P/E valuation range of the previous hundred years or so. That means it could be prudent for advisers to consider a new, higher valuation range for the S&P 500.

The U.S. stock market's P/E ratio, based on trailing 12 months' earnings per share, ranged consistently between seven and 21 times from 1870 to the late 1980s.

That measure, sacred to many, may be now out of date.

“Since 1990, however, nearly every long-standing U.S. stock market valuation guide has blown up,” Mr. Paulsen wrote.

The mean valuation of the trailing-12-month P/E ratio has increased by almost 50% since 1990, compared with its average between 1870 and 1990.

The trailing-12-month multiple for the market had a mean of 14 times from 1870 to 1990, according to Mr. Paulsen.

Since then, the mean has been about 20 times.

Right now, the P/E ratio for the S&P 500's trailing 12 months is about 16 times.

That puts it in the upper quartile of its historical valuation range, but still short of its highest levels over the past 25 years, according to Mr. Paulsen.

Such a period is “far too long to simply be discounted as a temporary aberration. But it's perhaps not yet long enough to declare a 'new' valuation range,” Mr. Paulsen wrote.

“Are stock investors still best served by heeding the prescripts of the historic valuation range?” he asked. “Or has a new and higher valuation range been established in the last quarter century, offering far more upside than suggested by the historic experience?”

In other words, has an actual paradigm shift occurred in historic valuation ranges of stocks?

Mr. Paulsen has no single, unified rationale to answer that question.

Indeed, over the past 25 years, myriad unique historic and economic events and trends have taken hold that perhaps explain the need for advisers to reassess P/E ratios.

Those include the tech revolution of the 1990s; 30 years of declining interest rates and inflation; the widest stock market participation in history; the end of the Cold War in the late 1980s; and less frequent recessions since World War II, according to Mr. Paulsen.

The breach in valuations looks much too lengthy to be called random, he wrote.

There is no doubt that P/Es have been rising as the stock market has soared.

For example, the P/E ratio of Raymond James Financial Inc. (RJF) has been steadily increasing since March 2009.

On Thursday afternoon, the stock price for RJF was $48.80, and the company had earnings of $2.60 a share in the past year. Its P/E ratio, therefore, was 18.7.

That is certainly higher than it was almost five years ago.

According to the company's 2009 annual report, it posted $1.29 a share of earnings and an equity share price of $17.11.

Raymond James Financial's P/E ratio at the time was 13.3.

Essentially, the P/E is outstripping the earnings, and that raises questions that advisers shouldn't ignore.

“It is getting difficult, as most have done, to simply dismiss this valuation divergence as a temporary aberration,” Mr. Paulsen wrote.

“Prior to 2000, the highest 25-year average trailing P/E was about 16. Today the 25-year average trailing P/E is about 19,” Mr. Paulsen wrote.

“Is this bull market running out of valuation room, and should investors therefore become more conservative based on the historical valuation range? Or does the stock market still offer considerable upside potential based on the norms of the last quarter century?” Mr. Paulsen wrote.

“We are as puzzled as anyone by these questions,” he wrote.

Perhaps advisers should take heed of both valuation ranges, Mr. Paulsen wrote.

The new range has persisted too long for advisers to ignore, but it would take several more decades of valuation divergences before the old, pre-1990 range can be fully discounted.

In the end, advisers “shouldn't be surprised if values rise above the old historic norms again in this recovery cycle, but perhaps should still curtail risk-taking before the upper end of the new valuation range is breached,” Mr. Paulsen wrote.

That is the kind of careful, understated call of a potential paradigm shift in the market that is hard to ignore.

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