A great explainer of Shiller's 10 year PE ratio

Robert Shiller (Yale Economist) computes a 10 year PE ratio which aims to smooth out short term earnings fluctuations to give a longer run view of market valuation.  The following is a really great explanation of this metric and some its uses.

My only quibble with the article is the bit about the level of the PE and the return on Treasuries.  This is basically the argument of the so-called Fed Model, which is on pretty shaky ground from a theoretical perspective.  I won't rehash the issue now as I've talked about this before here and here.

LNKD has a forward PE of 300.

Via counterparties: LNKD is trading off 300 times forward earnings.  Either profits have to increase a whole lot or the stock price will have to fall.  I know which one I'd bet on.

Robert Shiller on Stock Valuations

From Greg Mankiw: Robert Shiller thinks stocks aren't that cheap.

Why P/E ratios are a poor predictor of market performance.

The Lex Column in the Financial Times today talks about why raw aggregate P/E ratios are poor predictors of stock performance.  Good stuff.  But the final part of the article caught my eye.

Likewise, history shows there to be no predictive power for stocks when comparing equity yields with bond yields. Why should there be? Dividends are risky and rise with inflation; coupons are risk free and do not. It is like buying apples because pears are cheap. There are good reasons why equities are due a bounce – flaky valuation metrics are not among them.

This is basically a take down of the so-called Fed Model (not endorsed by the Fed) that argues that comparing bond yields to earnings yields reveals information about the level of the stock market.  I posted on this a few days ago here.  With bond yields low and earnings yields high, numerous "experts" are claiming this is a signal that the market is undervalued.   They are wrong.  It is a signal that bond yields are low and earnings yields are high.  That is all.

Stock valuation Haiku

P Es are lower

Time to buy say the experts

high risk premium

Shiller and Siegel on Stock Market Valuation.

Robert Shiller and Jeremy Siegel go to the mat on stock valuation.

HT Greg Mankiw

The lost decade

A great link showing how, as far as stocks are concerned, we gained pretty much nothing over the past decade. The last graph on PE ratios is worth a look if you don't read the whole article.

Inflation and stock prices.

I've been checking out a new blog on Reuters by a Rolfe Winkler. It's pretty good, although his recent posting on inflation and stock prices makes the common mistake of confusing nominal and real growth rates. In economics parlance, we call this inflation or money illusion.

The basic error of inflation illusion is that a nominal discount rate is used to present value a firm's cash flows while a real growth rate is used to grow them. The result is that when inflation increases, the discount rate goes up and the present value of cash flows declines. This leads to the oft-cited conclusion that stock prices will decline when inflation increases.

In fact, stocks are natural hedges against inflation because the cash flows are real. This means that they increase with inflation. As prices go up, the firm's revenue and cash flows increase accordingly.

At the simplest level, consider the Dividend Discount Model.

P = D1/r-g

D1 is the dividend expected next year. r is the nominal discount rate and g is the growth rate. An increase in inflation will increase r through the risk free rate. g will also increase at the rate of inflation. Because the numerator is r-g, the effect of inflation will cancel out.

Mr Winkler is not alone in suffering from inflation illusion. The effect has been well documented. The original idea of inflation illusion affecting stock prices was proposed by Franco Modigliani and Richard Cohn in 1979. Since then, numerous academics have studied the issue and found evidence of inflation illusion. For example, John Campbell and Tuomo Vuolteenaho find evidence in their American Economic Review paper in 2004. Yours truly also found evidence for inflation illusion in my 2002 Journal of Financial and Quantitative Analysis with Jay Ritter.

Inflation illusion also affects house prices, but that's a topic for another day...

S & P earnings...Fama and French comment

This issue keeps coming back like a bad penny. The issue of how S&P computes earnings ratios. My last post on it was here.

Fama and French have weighed in and argued that they use the method used by S&P, which in "normal" circumstances probably makes sense. But I disagree with them on this comment...

It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.

The S&P 500 is not a giant conglomerate. If a massive firm goes bankrupt and posts massive losses that outweigh it's market value, those losses are not absorbed by the other firms in the index as in a conglomerate. Once the firm has zero value, that's it. The losses are then absorbed by the creditors.

Jeremy Siegel responds...(on S&P's P/E ratios)

Jeremy Siegel recently caused a lot of fuss by arguing that S&P mis-reports earnings in the 500 index. I posted a comment on his idea here. Then S&P responded. At the time I agreed with Siegel and I disagreed with S&P (I still do).

Finally Siegel himself has re-entered the fray and confirms what I thought he was saying. Furthermore, he has enlisted Robert Schiller who also supports his arguments.

No doubt, S&P will still argue that Siegel's arguments are without merit, but I think that this issue is closed. Not value-weighting historical earnings of companies that loose huge amounts of money causes the stated earnings of the S&P 500 to be too low. The argument made by S&P that the index is just like a multi-division company is just plain stupid.

S&P's response to Siegel on PE ratios - S&P still misses the point

A letter today in the Wall Street Journal claims that S&P does compute earnings correctly. I've copied the letter below. The link to the letters page is here.

S&P Does the Earnings Correctly

In his "The S&P Gets Its Earnings Wrong" (op-ed, Feb. 25), Jeremy J. Siegel claims that Standard & Poor's systematically understates the earnings of the S&P 500. In his view, the recent losses of the financial companies in the S&P 500 should be discounted because of their diminished weights in the index.

His argument, however, fails the simple tests of both logic and index mathematics. A dollar earned or lost is the same, irrespective of whether it is earned or lost by a big index constituent or a smaller one.

Prof. Siegel's example of Exxon-Mobil illustrates why S&P's method of calculating earnings works. If large Exxon-Mobil earned $10 billion and small Jones Apparel lost $10 billion, index investors collectively -- and individually -- would bear a proportionate share of both Exxon's earnings and Jones's loss, despite the fact that the value of Exxon-Mobil's shares in the index portfolio is about 1,381 times the value of the Jones's shares.

To use an analogy, we could hypothetically view the S&P 500 as a single company with 500 divisions, with each division having earnings and an implicit market value. The smallest of these divisions could have an outsized loss that wipes out the combined earnings of the entire company. Claiming that these losses should be ignored or minimized because they came from a less valuable division is flawed.

Prof. Siegel's approach -- applying the weights based on market values to the results based on a company's earnings -- effectively mixes apples and oranges.

David M. Blitzer
Managing Director, Chairman of the Index Committee
Standard & Poor's
New York

I still think that Siegel is correct, and that Blitzer (and S&P) are missing the point. S&P is correct that the total earnings of the index is the sum of the earnings of the individual companies. But when computing a PE ratio, this approach is flawed if you want a PE ratio that can be comparable to an individual stock's PE. This is because the S&P 500 is NOT a multi division company in which the earnings of a bad division can wipe out the earnings of the rest of the company. These are separate individual companies.

When a stock with a tiny market value posts a massive loss, this loss will have a disproportional effect on the overall PE ratio of the index. If you want the PE of the index to provide some indication of the overall valuation of the market, you will have too high a PE using S&P's method.

I blogged on this a couple of days back. But my basic argument (and I think Siegel's) is that if you have a stock with a tiny value and a huge loss, it's impact on the PE should be trivial because if you buy the index today you'll only be buying putting a tiny amount of your money in that stock. By not value weighting the earnings (or losses) you are assuming that that stock makes up a much larger chunk of the index, when it doesn't.

Or put another way. You have two stocks in the index. One has a PE of 10, and is massive. The other has a negative PE and earnings equal to minus the earnings of the big firm. Is the PE of the index 10 or close to infinity? If you bought the big stock, you'd buy it off a PE of 10, and if you bought the tiny, big loss stock you'd buy it as basically an equity option.

So while S&P is mathematically correct, if they want a PE ratio that is actually economically meaningful, their approach is flawed.