It’s all relative

Happy March everyone,

You have doubtless seen the news that the Dow Jones is at levels last seen 12 years ago, yes? So 12 years worth of market gains have been erased by the current financial crisis. However, implicit in these sorts of statements is an assumption that the rational price levels were when the Dow was around its all-time high, c. 14,000 points. I have a big time quibble with that. The reason is that prices ought to be relative to business performance. This performance is most easily measured by a firm’s profits, or earnings. This relative relationship is captured with a P/E ratio, and we have talked at length about P/Es already on the blog, as well as what passes for a reasonable P/E.

The financial markets usually move in lock step with one another, so for this statistical section I am going to switch to another stock market index, the S&P 500. Twelve years ago the S&P 500 was at a P/E ratio of around 27.5x! This is a silly high number, but reasonable when compared with the even more ridiculously high P/E ratios of the S&P 500 around the time of the dot.com bubble of the late 90s, when the P/E for the market wa around 44x! My point is that prices of the financial market indices have fallen to 12 year lows and all of those financial market gains have been lost. However, 12 years worth of profits/earnings have not been lost. That means that the relationship between prices and profits has improved dramatically. For years and years, prices rose faster than earnings, resulting in a over-inflated asset values. This rationalization, and shaking out of the marginal, high-bidding investor, means that P/E ratios are reasonable and rational again. The average P/E ratio of the S&P 500 is around 13.5x. This compares to the historical average of around 15x. P/E ratios for the S&P 500 are at their lowest levels since 1985 and actually below their historical average. And again, this is one of the reasons that I am a buyer of stocks for the first time in many years right now. Yes, it’s true that the prices may fall further and that the economic turmoil will result in a loss of earnings for businesses and a commensurate decline in the value of the stock market, yet again. But the point is that businesses and the economy will survive and that is why it makes sense to be buying right now.

Jason