The cult of PE10 - so what?

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FFFollower
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The cult of PE10 - so what?

Post by FFFollower » Tue Oct 15, 2013 3:20 pm

I have been reading quite a bit here recently. I notice a rather odd paradox, and I would like to solicit thoughts. I will accept that PE10 has a degree of predictive capabilities, albeit with much skepticism. I will also accept that Market Timing has been proven, with more rigor then the proof of PE10's predictive capabilities, to be less effective long-term then buy and hold - i.e. it doesn't work. Why then the interest in debating PE10? What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing? Or is this merely an academic discussion born from boredom and too much research?

- Jason

Sidney
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Re: The cult of PE10 - so what?

Post by Sidney » Tue Oct 15, 2013 3:22 pm

I suppose to the extent that valuations impact expected future returns, it would impact decisions like retirement.
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Re: The cult of PE10 - so what?

Post by FFFollower » Tue Oct 15, 2013 3:23 pm

Sidney wrote:I suppose to the extent that valuations impact expected future returns, it would impact decisions like retirement.
Ahh. so non-investment related decisions such as working a few extra years, or changes to expense based upon expected outcomes? That makes a heck of a lot more sense to me.

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Re: The cult of PE10 - so what?

Post by crake » Tue Oct 15, 2013 3:25 pm

My simple understanding of the subject is that PE10 can be used as a long term predictor of expected returns. Market timing is more about seeking short term returns. PE10 does not tell us anything about the daily ups and downs of the market which market timers hope to capitalize on.

For example, if PE10 is high it might be a good idea to anticipate lower expected future returns. It should not be used as a signal to get in/out of the market.

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Re: The cult of PE10 - so what?

Post by abuss368 » Tue Oct 15, 2013 3:41 pm

I used to get more caught up in the various PE's back in the evil stock picking days. Now, not so much.
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Re: The cult of PE10 - so what?

Post by Sidney » Tue Oct 15, 2013 3:49 pm

abuss368 wrote:I used to get more caught up in the various PE's back in the evil stock picking days. Now, not so much.
Same here. Before I retired in 2007 I had a general feeling that valuations were running high and I stress tested my holdings to make sure we could make it cleanly through some early years with a bad sequence. But it didn't affect our investment decisions.
I always wanted to be a procrastinator.

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Re: The cult of PE10 - so what?

Post by JoMoney » Tue Oct 15, 2013 4:07 pm

Amongst the problems I have with PE10 as an indicator, is that despite the fact that it would have worked to predict a few times when the market got excessively high priced, there are times when it has given false indications (broken clock)... and if someone did use it to get out of the market, it's excessively slow at revealing when the market price is low. Some market timers like to use charts of different moving averages of different time periods as indicators with some to get out, and others to get back in, or believe the convergence of different time periods average has meaning. I've been down that road... it's silly. The further out the data is, the less bearing it has on the present, and it's as predictive of the future as a coin flip.
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Re: The cult of PE10 - so what?

Post by YDNAL » Tue Oct 15, 2013 4:43 pm

FFFollower wrote:I have been reading quite a bit here recently. I notice a rather odd paradox, and I would like to solicit thoughts. I will accept that PE10 has a degree of predictive capabilities, albeit with much skepticism. I will also accept that Market Timing has been proven, with more rigor then the proof of PE10's predictive capabilities, to be less effective long-term then buy and hold - i.e. it doesn't work. Why then the interest in debating PE10? What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing? Or is this merely an academic discussion born from boredom and too much research?

- Jason
Jason,

"The cult of PE10"... really?

Expected Return = Savings Rate + Earnings Growth + Speculation. THIS is Mr. Bogle's take on this.

The last variable in that equation can take prices to excessive (stratospheric?) levels:
- If/when it does, what can you reasonably expect going forward?
- What do you see throughout history, most obvious in 1999, in this chart (from May 2013)?
Image

I wouldn't suggest any metric to get-in, get-out of the Market. But, suggest awareness of what we MAY reasonably expect from the asset allocation at certain times. After all, the AA should be on Ability & Need for risk, how much risk are we take when our investment in Equities cost 35, 40 times the earnings ?
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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Re: The cult of PE10 - so what?

Post by kenyan » Tue Oct 15, 2013 4:47 pm

I mostly ignore all of that talk. It has some predictive capability, but mostly the P/E prediction plots look like someone fired a shotgun through a large rectangular aperture that is slightly tilted. Not terribly compelling, and something that would've gotten me laughed off the stage back in graduate school (w.r.t. hard science). Even if one does accept its limited predictions, it's difficult to come up with an actionable plan. Admirable attempts have been made, but any reasonable attempt IMO should (a) consider all other major investment options, and (b) acknowledge that it is another form of backtesting and may fail just like many other backtested strategies.

Maybe my ears will perk up when I start hearing about astronomical valuations and why "this time it's different." Tough to call, though.
Retirement investing is a marathon.

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Re: The cult of PE10 - so what?

Post by FFFollower » Tue Oct 15, 2013 4:50 pm

YDNAL wrote:
FFFollower wrote:I have been reading quite a bit here recently. I notice a rather odd paradox, and I would like to solicit thoughts. I will accept that PE10 has a degree of predictive capabilities, albeit with much skepticism. I will also accept that Market Timing has been proven, with more rigor then the proof of PE10's predictive capabilities, to be less effective long-term then buy and hold - i.e. it doesn't work. Why then the interest in debating PE10? What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing? Or is this merely an academic discussion born from boredom and too much research?

- Jason
Jason,

"The cult of PE10"... really?

Expected Return = Savings Rate + Earnings Growth + Speculation. THIS is Mr. Bogle's take on this.

The last variable in that equation can take prices to excessive (stratospheric?) levels:
- If/when it does, what can you reasonably expect going forward?
- What do you see throughout history, most obvious in 1999, in this chart (from May 2013)?
Image

I wouldn't suggest any metric to get-in, get-out of the Market. But, suggest awareness of what we MAY reasonably expect from the asset allocation at certain times. After all, the AA should be on Ability & Need for risk, how much risk are we take when our investment in Equities cost 35, 40 times the earnings ?
So what? What do you do differently having this knowledge? What actions have you personally taken because the magic indicator is digging the alarm? What actions do you recommend to others? Again, is it more a curious academic thing, or does the rubber meet the road in some action?

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Re: The cult of PE10 - so what?

Post by Browser » Tue Oct 15, 2013 4:55 pm

Perhaps PE10 is the antidote to the "cult of equities" that keeps insisting that the royal road to wealth and happiness is paved with stock certificates. The real road to wealth is paved with prudence and patience (two of my favorite girlfriends). Lowered expectations about future stock returns are a good thing. Maybe that will help people to realize they should work harder, save more, invest prudently and live within their means. If that turns out to have been wrong, where's the harm in that?
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Re: The cult of PE10 - so what?

Post by IlliniDave » Tue Oct 15, 2013 5:11 pm

FFFollower wrote:I have been reading quite a bit here recently. I notice a rather odd paradox, and I would like to solicit thoughts. I will accept that PE10 has a degree of predictive capabilities, albeit with much skepticism. I will also accept that Market Timing has been proven, with more rigor then the proof of PE10's predictive capabilities, to be less effective long-term then buy and hold - i.e. it doesn't work. Why then the interest in debating PE10? What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing? Or is this merely an academic discussion born from boredom and too much research?

- Jason
To an extent it's maybe more a matter of timescale. Market-timing "proper" is the act of moving in and out of markets based on short-term forecasts. Like, selling all you stocks and bonds because of the potential pending default later this week or something, and is generally characterized by frequent trading and high turnover (could be called the "strong" form of market timing). Sometimes the term is extended to cover any "action" an investor takes, no matter how slight, that in any way considers what returns might be in the future (it's perfectly cricket to consider what "risk" might be in the future, just not returns). When limited in scope and of moderate to long term in duration, it could be called the "weak" form of market timing. I've heard the term "tactical asset allocation" used by Bogle and others.

PE (or PE10) are long term predictors so don't fit well with the "strong" form of market timing because the PE mean reversion could happen tomorrow or 10 or even 20 years down the road. Some people will employ the "weak" form of market timing, to include me in all likelihood, should PEs hit extremes. If PEs got under 10-12 I'd likely increase my stock allocation by 10% and hold there until PEs hit 20 then ease back down to baseline allocation, expecting it could take a decade or more. If PEs got over 30 or 40 I'd probably decrease my stock allocation 10% and hold there, and when PE's eventually got back down around 20-25 ease back up to baseline allocation. I've seen no research to indicate whether that type of modest reaction to PE either helps or hurts. As I get closer to retirement I'll probably grow increasingly more concerned about easing away from very high PEs than leaning towards really low PEs.

That's what to me seems actionable concerning PEs, but I believe I'm in a distinct minority here.
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Re: The cult of PE10 - so what?

Post by grayfox » Tue Oct 15, 2013 5:22 pm

When you own a share of stock, what you have is a claim on future earnings, future dividends and some voting rights.

That's about it.

When you buy something, it makes sense to know what you are getting for your money. What might be the futures earnings and dividends that you are going to get?

Sherlock Holmes would take out his glass and look it over carefully. Past dividends might provide a clue. The trailing 12-months earnings might provide a clue. The trailing 120-months earnings, might provide a clue.

Or would you just buy a pig in a poke?

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Re: The cult of PE10 - so what?

Post by MnD » Tue Oct 15, 2013 5:32 pm

PE10 is barely more predictive than PE1.
PE10 is experiencing a near cult-like following lately because it "worked" well in 2000 as did PE1 _and_ in 2008 when PE1 didn't. PE1 failing to warn of overvaluation in 2008 due to outsized earnings coming from the financial, housing and other sectors directly tapped into the revenue streams from the housing, mortgage and debt bubble. The 2000 and 2008 declines permanently damaged many investors psyches for a life-time. PE10 holds the promise of a magic elixer to warn of the next 50% decline, which many apparently believe is something that now occurs at something less than a 10 year recurrence interval. Like moving averages and other simplistic technical "smoothings", PE10 will fail badly under some other set of economic conditions. Personally I think the present conditions, where present earnings are peak earnings and the rest of E10 contains earnings from both the tail end of the tech bust and all of the great recession quarters would be a very good example of where PE10 would be primed to be a false indicator of overvaluation.
Last edited by MnD on Tue Oct 15, 2013 6:30 pm, edited 1 time in total.

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Re: The cult of PE10 - so what?

Post by YDNAL » Tue Oct 15, 2013 6:05 pm

FFFollower wrote:
YDNAL wrote:I wouldn't suggest any metric to get-in, get-out of the Market. But, suggest awareness of what we MAY reasonably expect from the asset allocation at certain times. After all, the AA should be on Ability & Need for risk, how much risk are we take when our investment in Equities cost 35, 40 times the earnings ?
So what? What do you do differently having this knowledge? What actions have you personally taken because the magic indicator is digging the alarm? What actions do you recommend to others? Again, is it more a curious academic thing, or does the rubber meet the road in some action?
Are you asking serious questions, want a response, or just attempting to be challenging and........

Better yet, I don't have anything else to provide to your thread. Good luck!
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Re: The cult of PE10 - so what?

Post by Rodc » Tue Oct 15, 2013 6:05 pm

I can see P/E10 having some very limited value as a predictor of likely future returns on the money you already have.

If high you might be well advised to believe your returns will be lower than average. But you should always plan to get less than average because the odds of low returns are always high enough that you better make a plan that is ok in that event.

If low you might be forgiven for day dreaming you will do better than average, but of course the prediction is far too shaky to count on.

Also, it makes no sense to look at valuations in isolation. If bond returns are very low that also effects how the future may play out. I am very surprised we never seem to see a P/E10 AND bond yield market prediction. That would make more sense but I still doubt it would have much predictive power.

Market-timing "proper" is the act of moving in and out of markets based on short-term forecasts.
Not really. Market timing occurs on all time scales.

A problem with P/E10 for timing is the general mismatch in scale (like 20 years) vs the time scale most investors have. Most don't have that much invested until say 40, so the driver is savings rate until then, then 20 years where strategy might matter more, then you are into retirement and many are selling down stocks regardless. If you reassess where you are, your changing desire or ability to deal with risk, etc every 5 years or so that will probably play a bigger role in asset allocation even if you believe in P/E10.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: The cult of PE10 - so what?

Post by FFFollower » Tue Oct 15, 2013 6:26 pm

Browser wrote:Perhaps PE10 is the antidote to the "cult of equities" that keeps insisting that the royal road to wealth and happiness is paved with stock certificates. The real road to wealth is paved with prudence and patience (two of my favorite girlfriends). Lowered expectations about future stock returns are a good thing. Maybe that will help people to realize they should work harder, save more, invest prudently and live within their means. If that turns out to have been wrong, where's the harm in that?
+1

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Re: The cult of PE10 - so what?

Post by FFFollower » Tue Oct 15, 2013 6:35 pm

YDNAL wrote:
FFFollower wrote:
YDNAL wrote:I wouldn't suggest any metric to get-in, get-out of the Market. But, suggest awareness of what we MAY reasonably expect from the asset allocation at certain times. After all, the AA should be on Ability & Need for risk, how much risk are we take when our investment in Equities cost 35, 40 times the earnings ?
So what? What do you do differently having this knowledge? What actions have you personally taken because the magic indicator is digging the alarm? What actions do you recommend to others? Again, is it more a curious academic thing, or does the rubber meet the road in some action?
Are you asking serious questions, want a response, or just attempting to be challenging and........

Better yet, I don't have anything else to provide to your thread. Good luck!
Here is the thing YDNAL, and insight without action - while potentially interesting - is not valuable in an objectives-based game like investing. I have absolutely no issue with debating PE10. I simply view it in the same category as South Park... entertaining, potentially enlightening, but not going to affect what I actually DO.

A previous poster said they would increase their stock allocation if PE10 hit some threshold. This is tangible action. If this debate in PE10 drives towards this, then I am simply asking how to overcome the paradox in a forum dedicated to avoiding market timing (among other sins). If this debate doesn't drive to action, then thats fine too. Just make sure new posters dont get their wires crossed based on "zelotizm". Have like: "Disclaimer: Academic discussion. Not a call to action."

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Re: The cult of PE10 - so what?

Post by Prokofiev » Tue Oct 15, 2013 6:53 pm

FFFollower wrote:I have been reading quite a bit here recently.
I notice a rather odd paradox, and I would like to solicit thoughts.

Why then the interest in debating PE10?
What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing?

- Jason
You cannot accuse the BogleHeads of being a part of the "Cult of PE10", because Bogleheads.org was originally founded in an effort to ban a poster (Rob Bennett) from discussing PE10 and "valuation-informed investing" (his term). If anything, we are the anti-cult.
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Re: The cult of PE10 - so what?

Post by Jeff Albertson » Tue Oct 15, 2013 7:35 pm

Image

source: http://delong.typepad.com/sdj/2013/10/c ... -earn.html
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Re: The cult of PE10 - so what?

Post by William Million » Tue Oct 15, 2013 7:42 pm

We have PE10 because we have a decimal (base-10) number system. We came to use base-10 because our ancestors had 10 fingers.

There is no logical reason that PE10 is a more accurate predictor than PE7 or PE9 or PE11. While it is due to cultural evolution that we have base-10 and PE10, we should not expect equities to conform to these cultural biases.

Some researchers back-test to prove PE10 is predictive. However, the San Diego Padres posting a winning record also proved highly predictive of bull markets. (Well, there are 30 teams, so it had to work with at least one of them.)

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Re: The cult of PE10 - so what?

Post by staythecourse » Tue Oct 15, 2013 7:49 pm

like it out not the data is the data. Vanguard in its paper showed only about .4 in correlation of P/E 10 vs. .37 or so in P/E 1 in predicting future returns. Thus both are pretty useless. Now the fine print was more interesting it looks as if the correlation goes up to 0.8 or better when the P/E 10 is at the extremes (highly over or undervalued). That is probably the relevance. Then again those are the times emotions kick in of fear or greed so not sure if even if you know that nugget of info. one will have the emotional fortitude to do the right thing. As many found in the late 90's. It isn't like folks didn't know the market was overvalued yet it didn't stop the mass hysteria/ herd mentality. One should not be too overconfident that they are more different then everybody else when it comes down to it.

I am in the category of it is useless and ahve NO CLUE why anyone talks about it other then trying to sound smart, "Boy did you looke at the P/E10 recently looks like a great time to...".

Good luck.
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Re: The cult of PE10 - so what?

Post by IlliniDave » Tue Oct 15, 2013 7:58 pm

Rodc wrote:
Market-timing "proper" is the act of moving in and out of markets based on short-term forecasts.
Not really. Market timing occurs on all time scales.

A problem with P/E10 for timing is the general mismatch in scale (like 20 years) vs the time scale most investors have. Most don't have that much invested until say 40, so the driver is savings rate until then, then 20 years where strategy might matter more, then you are into retirement and many are selling down stocks regardless. If you reassess where you are, your changing desire or ability to deal with risk, etc every 5 years or so that will probably play a bigger role in asset allocation even if you believe in P/E10.
The different time scales is what I discussed in the rest of my post. I just distinguish between the highly speculative short term game that "traders" play and/or the panic run/hide or leap recklessly into the current hot market game; and what I believe is a prudent lean towards the odds in the longer term. Others don't make that distinction.

Where you are in life and the like certainly plays a role in allocation decisions. But no matter what my glide path/allocation turns out to be near/in retirement, If PEs start to push above 30 or higher I guarantee I will hold less stock then what my age/financial position-based allocation target is. I've touched that burner before. It hurt. That sort of discretion is built into my IPS.
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Re: The cult of PE10 - so what?

Post by letsgobobby » Tue Oct 15, 2013 8:05 pm

FFFollower wrote:
Sidney wrote:I suppose to the extent that valuations impact expected future returns, it would impact decisions like retirement.
Ahh. so non-investment related decisions such as working a few extra years, or changes to expense based upon expected outcomes? That makes a heck of a lot more sense to me.
As one of the 'usual suspects' who defends PE10 and whose IPS relies extensively on IPS, I'll expand on the above. In addition to investment-related decisions, I might also use PE10 and current bond yields to determine, for instance, when to save more money vs less; when to pay down debt vs not; whether to cut back on work/early retire or not; what my personal SWR might be; etc. In other words, it's more than just asset allocation. It's also how much risk to take overall in one's personal finances; and based on expected returns, what alternatives to investing might exist with a given dollar.

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Re: The cult of PE10 - so what?

Post by richard » Tue Oct 15, 2013 8:27 pm

PE and PE10 are the best metrics and they don't do very well, says Vanguard:

"We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns, although it has only been meaningful at long horizons and, even then, P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E10 ratio).

"The current level of a blend of valuation metrics contributes to Vanguard’s generally positive outlook for the stock market over the next ten years (2012–2022). But the fact that even P/Es—the strongest of the indicators we examined—leave a large portion of returns unexplained underscores our belief that expected stock returns are best stated in a probabilistic framework, not as a “point forecast,” and should not be forecast over short horizons."

https://personal.vanguard.com/pdf/s338.pdf

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Re: The cult of PE10 - so what?

Post by Dutch » Tue Oct 15, 2013 9:12 pm

Where is this cult you speak of?

You're setting up a straw man.

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Re: The cult of PE10 - so what?

Post by denovo » Tue Oct 15, 2013 11:03 pm

In 2008 P/E 10 wouldn't have predicted a crash, although it would have in 2000 or 1929. The problem with P/E 10 is that it can only detect bubbles that come from P, and not E. So in 2000, you had a lot of companies that literally had made no money that were being valued extremely high so P/E 10 and P/E itself were super high. By July 2008, the market had deflated a bit, and P/E 10 was a bit high at 20, but consider that P/E 10 is 23 right now. What made the Crash of 2008 different was that we had a BUBBLE IN THE E not the P. There was no doubt that the commercial and investment banks had respectable earnings, but what bore out were that those earnings were NOT sustainable. P/E data has no way of flushing out "bad or unsustainable earnings"
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Re: The cult of PE10 - so what?

Post by JoMoney » Wed Oct 16, 2013 5:58 am

staythecourse wrote:... Now the fine print was more interesting it looks as if the correlation goes up to 0.8 or better when the P/E 10 is at the extremes (highly over or undervalued). ...
...and without those few fat-tail extremes where the ratio managed to show some predictive ability, it had almost no predictive power the rest of the time.
" Are the “tails” wagging the dog (and reverting to the mean)? " https://personal.vanguard.com/pdf/s338.pdf

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Re: The cult of PE10 - so what?

Post by cjking » Wed Oct 16, 2013 7:20 am

FFFollower wrote:Why then the interest in debating PE10? What is actionable as a result of this calculation, whilst also considering the prove points of Market Timing? Or is this merely an academic discussion born from boredom and too much research?
Here are two semi-hypothetical uses of PE10, i.e. I've simplified matters/numbers for demonstration purposes.

1. Asset allocation. PE10 says USA index is yielding 3.5%, world index 5%, Europe and emerging markets indexes 6%. I (a UK investor) allocate equities 100% to Europe. (If I didn't have any valuation data/knowledge/opinions, my default allocation would be 100% world.)

2. Withdrawal rates. I want to know the maximum I can withdraw from an equity portfolio without running it down. Based on Shiller PE10 data, I know that spending no more than 83%/PE10 would have met this goal over the 130-year period the data covers.

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Re: The cult of PE10 - so what?

Post by cjking » Wed Oct 16, 2013 7:38 am

William Million wrote:There is no logical reason that PE10 is a more accurate predictor than PE7 or PE9 or PE11.
Yes, 10 is arbitrary. For most purposes, 7, 9 or 11 would probably work more or less as well. Knowing that tells you nothing about how well 10 does (or doesn't) work for a particular purpose.

(Edited to add: and if you want to say it is good or bad, you must state for what purpose. It may well be useless for whatever purpose you have in mind, but not for several others. So saying it can't be used for timing, as others have done, is likely arguing that a screwdriver is useless for hammering in nails. True, but not a reason to throw the screwdriver away.)

Your argument only debunks PE10 if you are attributing a great degree of precision to PE10 such that the differences between it and the other periods matter. PE10 doesn't have that precision, that doesn't make it worthless.

Essentially your criticism is a straw man argument.

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Re: The cult of PE10 - so what?

Post by Browser » Wed Oct 16, 2013 8:02 am

Here's the thing. You either believe that valuations have something to do with stock returns or you don't. Bogle, for one, believes that they do and I personally think it is whistling past the graveyard to believe otherwise. If you give that view some credence, then you either believe that valuations can be evaluated or that it's impossible to do so. Again, I see the latter as a rather philistine view. Now, if you're still with me, instead of whistling past the graveyard, we've arrived at the point where we have to ask how to best evaluate or estimate stock valuations. On a relative basis, there's a great deal of agreement that normalized P/E is as good, if not better, than other measures; i.e., Shiller CAPE or PE/10. The only issue that is worth debating is whether there is currently a better indicator of stock valuations. So let's stop the goofy talk about CAPE being worthless, superstitious, cultish, and so forth. While all our financial measures are rubber yardsticks, they can still have some usefulness. For those seeking the instant gratification of predicting what stocks will do tomorrow, thinking about stock valuations may seem aimless, but that's no reason to curl up in a ball.
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Re: The cult of PE10 - so what?

Post by cjking » Wed Oct 16, 2013 8:32 am

It seems most people (including Vanguard) want to evaluate PE10 according to its ability to predict stock prices over a fixed period of time. (To be fair, even Shiller evaluated it for that purpose.)

That's not what it does best. Nothing is going to do that well, because performance over a fixed period of time depends on two semi-random end-points: there is a lot of noise that goes into determining price on both the start and end-dates.

On the other hand, if (to make up a random example) you used it to predict what sort of return you would get, on average, if you sold shares in equal quantities every month for n years, it would likely have much greater predictive ability, because in an average of lots of noisy values, the errors/noise get averaged out.

A screwdriver is not very good for hammering a nail. If the screwdriver is the only tool available, don't discard it, consider if your broader objective could be met by using a screw instead of a nail.

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Re: The cult of PE10 - so what?

Post by staythecourse » Wed Oct 16, 2013 9:47 am

cjking wrote:On the other hand, if (to make up a random example) you used it to predict what sort of return you would get, on average, if you sold shares in equal quantities every month for n years, it would likely have much greater predictive ability, because in an average of lots of noisy values, the errors/noise get averaged out.
I think that would be interesting to see if that was true or not. Since we don't have the info. if that analysis has been done your guess is just that a guess. Investing is all about probabilties vs. possibilities. Unless you have some data that has been crunched your analysis is the possiblity it may be true. Funny how folks will trust a possiblity over known probabilities (stocks doing best over the long run). It is very dangerous to believe things as true without data to back it up. I don't sit around an read financial articles so if that data has been looked at in that manner I would love to read it myself, but if it now then yours is just a hypothesis that may or may not be wrong.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: The cult of PE10 - so what?

Post by staythecourse » Wed Oct 16, 2013 10:03 am

Browser wrote:Here's the thing. You either believe that valuations have something to do with stock returns or you don't. Bogle, for one, believes that they do and I personally think it is whistling past the graveyard to believe otherwise. If you give that view some credence, then you either believe that valuations can be evaluated or that it's impossible to do so.
You are too quick to breeze through this part of your analysis. I would say this is the crux of the entire argument. Can't speak for others, but using your algorhythm approach to this thinking yes I believe valuations matter, but no don't think they can be evaluated to be useful. I have not seen any concrete data to say otherwise. If you have an article I would be more then happy to read it. All I know is from vanguard's paper showing the predictive ability to be around 0.41 or so which is worse then flipping a coin. The value seems to be at the times when markets are severely over or under valued by the same measure of valuation, correlation goes up to 0.8 or so (much more useful).

Unlike others, I don't believe in valuations being useful BUT would love to be shown otherwise. Investing would be much easier if I was wrong. I just have not seen any advantages of it. For example I tried crunching the numbers of using earnings yield and dividend yield to determine one's stock/ bond allocation. I looked at the numbers and stuck it in Simba's spreadsheet and found not much of a difference to just holding a static 50/50 portfolio. And that is without including costs of transactions for dynamic asset allocation.

The ultimate sign of there not being a use is if there was one would have a P/E10 mutual fund. Do you think if this valuable valuation tool known since Ben Graham existed someone would not have profited of it? And if they did not bid up the prices on market impact not make it less useful after costs? Reminds me of that old story of the professor walking down the street with the student and seeing a hundred dollar bill on the street. The professor tells the student there is no reason to pick it up because if it was a real hundred dollar bill it wouldn't just be laying there and not been picked up someone else walking by by now. I feel folks look at P/E10 in the same manner (as a valuation tool).

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: The cult of PE10 - so what?

Post by grayfox » Wed Oct 16, 2013 10:20 am

Mathematically, there are one of two possibilities that you can expect from above-average stock valuations:

A. Earnings and dividend growth rate will be higher than average in the future
B. Stock returns will be lower than average in the future

Consider the Gordon growth model:

Image

Image

Suppose dividend yield, D/P, is 4%, then 3% growth will give 7% return.
If prices rise and D/P falls to 2%, then growth must be 5% to get 7% return.

So which do you expect, A or B?
If you don't think that higher stock valuations forecast lower returns, then you must be expecting higher growth.
Last edited by grayfox on Wed Oct 16, 2013 10:28 am, edited 1 time in total.

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Re: The cult of PE10 - so what?

Post by grayfox » Wed Oct 16, 2013 10:28 am

.....

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Re: The cult of PE10 - so what?

Post by letsgobobby » Wed Oct 16, 2013 10:30 am

staythecourse wrote:
Browser wrote:Here's the thing. You either believe that valuations have something to do with stock returns or you don't. Bogle, for one, believes that they do and I personally think it is whistling past the graveyard to believe otherwise. If you give that view some credence, then you either believe that valuations can be evaluated or that it's impossible to do so.
You are too quick to breeze through this part of your analysis. I would say this is the crux of the entire argument. Can't speak for others, but using your algorhythm approach to this thinking yes I believe valuations matter, but no don't think they can be evaluated to be useful. I have not seen any concrete data to say otherwise. If you have an article I would be more then happy to read it. All I know is from vanguard's paper showing the predictive ability to be around 0.41 or so which is worse then flipping a coin. The value seems to be at the times when markets are severely over or under valued by the same measure of valuation, correlation goes up to 0.8 or so (much more useful).

Unlike others, I don't believe in valuations being useful BUT would love to be shown otherwise. Investing would be much easier if I was wrong. I just have not seen any advantages of it. For example I tried crunching the numbers of using earnings yield and dividend yield to determine one's stock/ bond allocation. I looked at the numbers and stuck it in Simba's spreadsheet and found not much of a difference to just holding a static 50/50 portfolio. And that is without including costs of transactions for dynamic asset allocation.

The ultimate sign of there not being a use is if there was one would have a P/E10 mutual fund. Do you think if this valuable valuation tool known since Ben Graham existed someone would not have profited of it? And if they did not bid up the prices on market impact not make it less useful after costs? Reminds me of that old story of the professor walking down the street with the student and seeing a hundred dollar bill on the street. The professor tells the student there is no reason to pick it up because if it was a real hundred dollar bill it wouldn't just be laying there and not been picked up someone else walking by by now. I feel folks look at P/E10 in the same manner (as a valuation tool).

Good luck.
Well, you just said yourself that PE10 is increasingly useful at extreme valuations. That is how my IPS uses it. It has been quite helpful over the years at extreme valuations (my asset allocation really doesn't shift more than 10% from baseline unless PE10 is less than 10 or greater than 30).

Furthermore I think you are misinterpreting what it means to say that "43% of variance of future real stock returns" is explained by PE10. It does not mean "worse than flipping a coin". It means that considering all the dozens or hundreds or thousands of variables which influence long term stock returns, a single variable (PE10) explained nearly half. If PE10 were no better than flipping a coin, in a world with 10 variables wouldn't you expect it to have explanatory power of no more than 1/(2)^10, or essentially zero? That is what the Vanguard paper found for variables such as corporate profit growth and consensus earnings margins: explanatory power of zero.

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Re: The cult of PE10 - so what?

Post by Browser » Wed Oct 16, 2013 10:41 am

I agree with staythecourse that valuations are not readily exploitable by investors. If they were, then they'd be arbitraged away for market timing purposes and be useless. Even so, I think we may be too quick to assume that valuations are useless information. If you have a predictive relationship between PE10 and 7-10 year returns, represented by a correlation of 0.4, this would seem to suggest valuations are useful. This predictive relationship is not easily arbitraged away by market traders and investors because of the very long time horizon involved. For that to happen, you'd need to have large numbers of individuals, funds, and other traders who are willing to buy or sell stocks based on a valuation index and wait 7-10 years for the expected result to be realized. For the individual investor to exploit this relationship, he needs to be prepared to accept a long time horizon. That's just about impossible for investors to do, even those who purport to believe in long-term buy-and-hold investing. Any investment strategy has the risk of failure. If it didn't, then everyone would follow it and it wouldn't work anymore. Most people aren't prepared to wait 7-10 years for a strategy to pay off and wind up empty-handed for their efforts, which could certainly happen with any imperfect strategy.
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Re: The cult of PE10 - so what?

Post by cjking » Wed Oct 16, 2013 1:29 pm

staythecourse wrote:
cjking wrote:On the other hand, if (to make up a random example) you used it to predict what sort of return you would get, on average, if you sold shares in equal quantities every month for n years, it would likely have much greater predictive ability, because in an average of lots of noisy values, the errors/noise get averaged out.
I think that would be interesting to see if that was true or not. Since we don't have the info. if that analysis has been done your guess is just that a guess. Investing is all about probabilties vs. possibilities. Unless you have some data that has been crunched your analysis is the possiblity it may be true. Funny how folks will trust a possiblity over known probabilities (stocks doing best over the long run). It is very dangerous to believe things as true without data to back it up. I don't sit around an read financial articles so if that data has been looked at in that manner I would love to read it myself, but if it now then yours is just a hypothesis that may or may not be wrong.

Good luck.

I have done the numbers, PE10 is much more useful for predicting averages. My apologies for diffident language that gave a misleading impression.

I actually got the idea of the importance of averaging from Andrew Smithers, in his book "Valuing Wall Street" where he discussed a different valuation measure (that usually says the same thing as PE10.) He made the thing to be predicted something he called "hindsight value", the average annual returns experienced by 40 different investors with holding periods respectively of 1 to 40 years.

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Re: The cult of PE10 - so what?

Post by linenfort » Wed Oct 16, 2013 1:35 pm

"So what" indeed. Especially since the OP has not bothered to define PE10.
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Re: The cult of PE10 - so what?

Post by letsgobobby » Fri Oct 18, 2013 2:22 pm

Looking at 2003 real earnings, it seems like we are now past the 'abnormal' earnings from the 00-02 tech bust. Therefore there is only one, not two, recession built into current PE10 values, possibly meaning it's not as unrepresentative as some have claimed.

I'll grant that the 07-09 earnings trough was a doozy. Not sure exactly how to use that, or not. There have been plenty of other very bad recessions in PE10 data and at extremes (PE10 > 25) there still have been few or no cases of exceptionally good returns. Once you get over PE10 20 or especially 25 or 30, there are no exceptions to the rule that high PE10 presages low real returns (not necessarily negative).

If today's market gains hold, we'll close more or less at PE10 25 tonight. I'm out of whack and need to rebalance anyway, so I'll do that now. I'm going to do it by selling US stocks (proportionally large and small/small value) and maintaining international stocks, which effectively increases my international allocation percentage.

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Re: The cult of PE10 - so what?

Post by Clearly_Irrational » Fri Oct 18, 2013 3:12 pm

Although no single indicator should be used to make investing decision, for me PE10 has two uses:

1) As an leading indicator of the mean of the future distribution of stock returns if I were to invest money now. This helps to answer questions like "Am I saving enough?" and "What should my stock and bond split be?".

2) As an indicator that the market has entered a period of irrationality and that the non-normality of the stock market return distribution is more likely to show itself in the time period ahead. This helps me to answer questions like "Should I buy and hold right now?" and "Are my current holdings appropriate for my risk preferences and if not should I change my asset mix, draw down my investments or purchase insurance?".

I have evaluated the other PE ratios including PE1, Price to Peak earnings, Tobin's Q and Market Cap to GDP, but despite their own individual merits I believe that PE10 does the best job of detecting the sort of events I'm interested in. (The 1929 & 2000 crashes being the prime examples)

Stock market investing is a complex multi-variable problem with incomplete information and positive feedback loops. Just because one of our gauges doesn't tell us everything we want to know doesn't make it useless in our operation of the Rube Goldberg contraption.

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Re: The cult of PE10 - so what?

Post by JoMoney » Sat Oct 19, 2013 4:28 am

Irregardless of price, the earnings on the S&P500 are currently about double what they were in 2003.
Back in 2003 they were about double what they were in 1993, and from there a little less then double what they were in 1983, similarly to 1973, and you can keep going back... the earnings today are not way out of line from historical growth (4-6% + inflation).

In November 1999 the "Oracle of Omaha" Warren Buffett gave his famous Sun Valley presentation . In the speech, he identified that stock prices were way out of line. In order to justify the higher stock prices at the time, he explained that there were two factors to consider in trying to justify how such extremely high prices relative to the earnings could continue:
Warren Buffett wrote:(1) Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options.
Kind of prescient of where we are today. However, 14 years later today we have more than doubled the earnings from the levels then, but we have failed to double the market price. In fact, the S&P500 is not too much higher today then it was then ($1400 vs $1700 today). His view seemed to be that stock earnings yield being half the risk-free bond rates were way out of line. Today, we are in nearly the opposite situation. 10 year gov. Bond yields are nearly half the earnings/price of the S&P500 ( http://online.wsj.com/mdc/public/page/2 ... yield.html )
Warren Buffett wrote: (2) Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major reslicing of the pie just isn't going to happen.
Corporate profits relative to GDP did practically double after 1999 ( http://research.stlouisfed.org/fred2/graph/?g=cSh ), there is all sorts of different explanations of this, but the reasoning Buffett suggested may be inline with some 99%er views that are off topic and maybe best to avoid discussing here.

The point I want to make, is that even if someone thinks the corporate profits we have today are unsustainable, the price is still not out of line if you compare it to the other options (bonds). Buffett has stated his view on current market prices as being "more or less fairly priced". I wouldn't suggest anyone be invested in the stock market if they thought the money might be needed for something near term, or really if they had any objection at all, but I would suggest that maybe the CAPE formula isn't in sync with the current times, and caution about:
Warren Buffett wrote:And as is so typical, investors projected out into the future what they were seeing. That's their unshakable habit: looking into the rear-view mirror instead of through the windshield. What they were observing, looking backward, made them very discouraged about the country.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The cult of PE10 - so what?

Post by Rodc » Sat Oct 19, 2013 8:19 am

linenfort wrote:"So what" indeed. Especially since the OP has not bothered to define PE10.
Google "Shiller CAPE" or "Shiller P/E10"

You can get all the data by Googling "Shiller P/E10 data"

P/E10 is well defined and well known, which is why the OP did not provide a definition in the thread.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: The cult of PE10 - so what?

Post by LH » Sat Oct 19, 2013 12:39 pm

Pe10 may just be the lucky monkey of all the series that have been examined for predictive value.

Be interesting to see in 20 to 30 years if its still considered predictive of anything.

Something, is certainly going to match up.

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Re: The cult of PE10 - so what?

Post by denovo » Sat Oct 19, 2013 4:16 pm

What if the bubble is in the E? :happy
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Re: The cult of PE10 - so what?

Post by JoMoney » Sat Oct 19, 2013 6:16 pm

denovo wrote:What if the bubble is in the E? :happy
That's always the risk in stocks. Earnings are not stable, bond yields are fixed. If earnings dropped in half, stock earnings would be quite comparable to gov bond yields, and in that sense a whole lot risker.... but current earnings are not out of line with past earnings growth. The future is always uncertain, there could be a disaster tomorrow that ends it all, and as we saw during the recent political fiasco even gov bond payments could theoretically be uncertain.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The cult of PE10 - so what?

Post by tadamsmar » Sat Oct 26, 2013 4:06 pm

grayfox wrote:When you own a share of stock, what you have is a claim on future earnings, future dividends and some voting rights.
You don't have a claim on future earnings.

You do have a claim to the the funds from the price that you manage to get it sold at.

"Claim" is a quite exact term, not some vague metaphor that one can use to fuzz up one's thinking.

Now, if you bought all the shares in a company and took it private, yeah, you have a claim on future earnings.

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Re: The cult of PE10 - so what?

Post by JoMoney » Sat Oct 26, 2013 7:12 pm

tadamsmar wrote:
grayfox wrote:When you own a share of stock, what you have is a claim on future earnings, future dividends and some voting rights.
You don't have a claim on future earnings.

You do have a claim to the the funds from the price that you manage to get it sold at.

"Claim" is a quite exact term, not some vague metaphor that one can use to fuzz up one's thinking.

Now, if you bought all the shares in a company and took it private, yeah, you have a claim on future earnings.
I think the shareholder has the claim on it, it's just that we might have to wait a while to redeem our claim and are subject to market vagaries that could destroy the value of that claim before it's realized. Theoretically, you wouldn't need to buy all the shares and go private, you just need a controlling interest where you can put "your girl/guy(s)" on the board or put some proposal together and force a shareholder vote... and if the potential value from doing something like that existed, there are private equity firms and activist shareholders that often step in to make these things happen. While it's doubtful any of us smaller shareholders can stake these claims individually, when the opportunities exist to create value from those future earnings, the market often finds a way to work that into the price. So yes, while our claim on those earnings isn't always reflected in the short term prices, hopefully the longer-term "weighing machine" on the value will materialize in the market price/dividends.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The cult of PE10 - so what?

Post by stlutz » Sat Oct 26, 2013 8:01 pm

Why then the interest in debating PE10?
Part of it is that a lot of people here used to pick their own stocks, and when they did, they were value investors in the Graham & Dodd sense of the term. As i recall, they suggested using PE7 as valuation metric for individual stocks. Despite moving away from stock picking to indexing, most of us still believe that "valuation matters." As such, PE10 as an indicator is of more interest than, say, some technical indicator.

That said, I'm not aware of any PE 10 thread garnering as many posts as the 200 day moving average thread did. :twisted:

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