High P/E = high future returns?

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learning_head
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High P/E = high future returns?

Post by learning_head »

It's been said a number of times on these threads that P/E (and P/E10) have some predictive power, explaining maybe 40% of future returns where higher PEs imply lower returns in following 10 years. (In part, this is based on this Vanguard paper). So, just knowing this, I would expect that when I look at data, higher PEs should be followed by lower future returns more often than not. It should not be 100% of the time but clearly more often than not.

I am having difficulty "seeing" this though when I look at sample numbers and thinking about why they show what they show. Here is sample PE1 data from http://www.multpl.com/table, annotated with my observations

(Overall PE1 Mean: 15.51 / Median: 14.55)

Jan 1, 1996 18.08 <-- PE seems "stretched" / "Irrational exuberance" comes out... yet a very good run follows
Jan 1, 1997 19.53
Jan 1, 1998 24.29 <-- very high PE - we should go down soon
Jan 1, 1999 32.92 <-- very very high PE - clearly need to be down
Jan 1, 2000 29.04 <-- we did NOT go down after all during last few years and only went up further with earnings catching up even more, thus lowering PE - so I guess we are on the right track after all... PE is at least now moving in right direction - guess it's the "new world" after all... oops
Jan 1, 2001 27.55
Jan 1, 2002 46.18 <-- depth of recession - but look how huge the PE is - it means exactly opposite of what it is supposed to predict
Jan 1, 2003 31.43 <-- about to start nice bull run and PE is very high, like in 1999-2000 - suggests collapse is coming
Jan 1, 2004 22.73 <-- PE is still very high but we are just starting the bull run
Jan 1, 2005 19.98
Jan 1, 2006 18.05
Jan 1, 2007 17.36
Jan 1, 2008 21.46 <-- high PE right before impending collapse - hey, PE seems to work here as expected
Jan 1, 2009 70.89 <-- this is more than twice as high as Jan 1,1999, yet this was around the "generational" low!Strong opposite to traditional PE interpretation.
Jan 1, 2010 20.70 <-- uh, oh this seems high... but next 4 years were a huge bull run
Jan 1, 2011 16.30
Jan 1, 2012 14.87 <-- market jumped from 2010 to 2012 but now supposed to have even higher returns because PE got lower?? Seems opposite to what PE is supposed to help explain.
Jan 1, 2013 17.03
Jan 1, 2014 18.19 <-- is this like 1996, right before a big bull run? or is this like 2007-2008 right before a big drop?

So, how can PE have any kind of positive predictive power (with high PE meaning lower future returns)? It seems like in last 20 years it was more of an opposite predictive power instead... Seems like in last 20 years, "High PE = High future returns" was more predictive in fact...

And there is even a clear explanation for why that is - P/E can be high because either P is "abnormally" high or because E is "abnormally" low. So, what may seem like a high PE could just mean a relatively low E that will soon grow to get PE back into its "normal" place.

So, should not PE have 0 predictive power or even negative (compared to its usual semantics that people use)? Yet many people a lot smarter than me clearly see something else in the data...

P.S. In case it was not clear... I do NOT really think high PE means high returns, quite the opposite - just looking for help in interpreting the data right!
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nedsaid
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Re: High P/E = high future returns?

Post by nedsaid »

This is a really interesting post. It reminds me of what the market pros used to say about cyclical stocks. Buy when the P/E's are high and sell them when they are low. Cyclical stocks are those that are very sensitive to the economy, if the economy does great these companies do great. Their earnings tend to fluctuate pretty wildly, high when times are good and low when times are bad.

As Cyclical stocks would be late in an economic cycle, earnings would be great but the stock price would start to soften. The market was smart enough to know that the great earnings wouldn't last much longer. So softening prices and great earnings would show a relatively low P/E and these type of stocks would look like "bargains." When the inevitable recession would hit, earnings would crater and the stock price would drop but not as much as one would think because the market knew that at some point the economy would recover. Cratering earnings and a lower stock price (though not as low as bad earnings would suggest) would create a high P/E stock. In this case, a cyclical stock could be a screaming bargain though the P/E ratio would not suggest that.

So there is more to all of this than just looking at P/E ratios. It also makes a difference if you are looking at forward P/E's based on future estimated earnings or trailing P/E's based on the last year's actual earnings. Both should be looked at but I actually take more stock in forward looking P/E's. So you have to look under the hood a little bit.
A fool and his money are good for business.
am
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Re: High P/E = high future returns?

Post by am »

Interesting post. Valuations matter but only to give a range of expected returns, and only based on past data. That is why the boglehead principle of staying the course is so critical. I often have an urge to do something to increase returns like fiddle with portfolio, reduce stocks exposure in response to high PE 10, etc. but have become mature enough now ( thanks to bogleheads) that I always stay the course. When I get closer to my financial goals, I will surely reduce stock exposure but not in response to valuations as the OP nicely outlined.
RenoJay
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Re: High P/E = high future returns?

Post by RenoJay »

The bigger indicator for me is that lately I've seen lots of posts, articles, new stories, etc. with compelling-sounding reasons about why stocks are not expensive, why they should keep going up, etc. That's my queue to rebalance out of equities a bit. Similar favorable stories were very common in 1999 and 2007.
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siamond
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Re: High P/E = high future returns?

Post by siamond »

Very interesting post indeed. PE1 isn't terribly meaningful though, being too sensitive to the 'vagaries of the day (well, the year)'. Would you (the OP) have the patience to rebuild the same kind of list using PE10, and see what goes?

I have to say that I struggle too with those predictive models, whether it's the PE10 or the famous Gordon equation. Not quite sure what to believe...
steve_14
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Re: High P/E = high future returns?

Post by steve_14 »

Thanks, good post. It's important to remember that the mutual fund industry makes money two ways: By convincing you that it can pick stocks, or by convincing you that free lunches exists in simple, publicly available stock ratios (P/E, P/B, P/S in the case of "fundamental indexes", momentum, etc). So expect to see these ratios marketed far beyond their actual value going forward.
steve_14
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Re: High P/E = high future returns?

Post by steve_14 »

siamond wrote:Very interesting post indeed. PE1 isn't terribly meaningful though, being too sensitive to the 'vagaries of the day (well, the year)'. Would you (the OP) have the patience to rebuild the same kind of list using PE10, and see what goes?
The reason the P/E morphed into the P/E 10 is because it had worked well recently. If you avoid recency bias, you can see from the Vanguard paper that the P/E 10 has only modestly more predictive value than the P/E 1 (.38 vs .43). If you expect the P/E 10 to work any better than the P/E 1 going forward, you're likely overvaluing it.
stlutz
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Re: High P/E = high future returns?

Post by stlutz »

I have to say that I struggle too with those predictive models, whether it's the PE10 or the famous Gordon equation. Not quite sure what to believe...
Me too. Future nominal stock returns will depend upon:

--inflation
--GDP growth
--profit margins
--investor allocation preferences of stocks vs. bonds
--how companies choose to raise capital (debt vs. equity)

There simply is no rule to say what these must be in the future. All predictions about future market returns take historical averages of the above and project them forward in time and claim that the resulting value "is expected". The reality is that markets aren't actually consulting the history books. Future equity returns are always highly uncertain, regardless of whatever metric/ratio somebody wants to promote is saying.
letsgobobby
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Re: High P/E = high future returns?

Post by letsgobobby »

I think you've just proved that there is such a thing as momentum in the short run, apparently a new "factor" and also what Graham referred to as the voting machine.

I'm more interested in the long run, what Graham called the weighing machine.

Vanguard's paper referred to 10 year returns. If I recall 20 year returns are more significantly impacted by PE10 than 10 year returns.

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

That said, PE1 isn't useless but it's useless to predict 1-2 year returns.

http://www.crestmontresearch.com/docs/S ... -11x17.pdf

http://www.crestmontresearch.com/docs/S ... th-PEs.pdf

Easterling's two books also contain a few useful charts, in which future returns (10 year, I believe) are highly correlated with initial PE values. I don't have the book in front of me right now.

At the end of the day there is no use trying to persuade or convince people that valuations matter. This argument's been had ad nauseum. From a selfish standpoint I suppose I'm happy with that: as long as investors are just as eager to buy stocks when PE10 is 40 as they are when PE10 is 12 (and we've had both those situations in the last 15 years), I believe strongly I will increase my annualized returns while decreasing volatility over my investing lifetime.

You'll have to do what you want.
am
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Re: High P/E = high future returns?

Post by am »

What are you going to do when PE 10 is 40? What else is there to buy that will give you reasonable growth? Didnt the Vanaguard tactical allocation funds switch to fixed percentages now? Valuations matter but how are they actionable?
letsgobobby
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Re: High P/E = high future returns?

Post by letsgobobby »

am wrote:What are you going to do when PE 10 is 40? What else is there to buy that will give you reasonable growth? Didnt the Vanaguard tactical allocation funds switch to fixed percentages now? Valuations matter but how are they actionable?
Last time PE10 was 40 I had 0% stocks. Next time, I'll be no more than 20% stocks, and maybe as low as 0%. I'll hold bonds or cash as the alternative. For me, such extremes in PE10 are indeed actionable.
am
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Re: High P/E = high future returns?

Post by am »

When will you get back in? There are so many possibilities like a crash that happens next month or 8 years later, low returns for the next 18 years, high returns for an additional 4 years followed by ___, PE remaining between 35-45 for X number of years, etc.
letsgobobby
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Re: High P/E = high future returns?

Post by letsgobobby »

Well in 2000 I ended up waiting 2-3 years, then stayed only lightly invested until 08-09 when I finally became fully invested. Since I started investing in the late 90s you could call that a 10 year wait. Definitely not for everybody. Like I said, not trying to persuade anyone of anything as that has been a useless cause. I am only describing what I did last time, and what I would do again if prices got that crazy.

Right now PE10 is 22-26 depending on whether you use old or new calculations. So not extreme at all, just not cheap. In my opinion current valuations are not actionable. They still tell me to expect muted returns for the next decade but I'm not *doing* anything because of those expectations.
garlandwhizzer
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Re: High P/E = high future returns?

Post by garlandwhizzer »

I think PEs have reliable predictive value when they reach very extreme levels either low or high. Extreme PEs directly reflect extreme investor sentiment levels, either pervasive panic or euphoria which is what drives net buying or selling of stocks and therefore PEs. Lowest PEs occur when all hope has finally been abandoned, i.e.2008-9 when there was the real threat of financial collapse and a worldwide rerun of the Great Depression, also, 1982 when inflation was running at 15% annually and high interest rates caused a severe recession, negative growth coupled with massive inflation. Alternately, highest PEs are caused by generalized euphoria, the "this time it's different scenario. The highest PEs in US history came with dot come euphoria or, even more dramatically, the Japan stock bubble that popped in 1990 where PEs reached astronomical levels never before or since seen anywhere in the world. At those rare moments PEs are reliably predictable but you need lots of discipline to go against the hoards running in the other direction. When PEs are in a middling zone like now (generous but not extreme), future returns historically have a wide range of outcomes, although the central tendency is for higher PEs to forecast lower returns and vice versa. Based on this I believe our future returns from here are likely but not certainly to be below historical norms.

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siamond
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Re: High P/E = high future returns?

Post by siamond »

steve_14 wrote:
siamond wrote:Very interesting post indeed. PE1 isn't terribly meaningful though, being too sensitive to the 'vagaries of the day (well, the year)'. Would you (the OP) have the patience to rebuild the same kind of list using PE10, and see what goes?
The reason the P/E morphed into the P/E 10 is because it had worked well recently. If you avoid recency bias, you can see from the Vanguard paper that the P/E 10 has only modestly more predictive value than the P/E 1 (.38 vs .43). If you expect the P/E 10 to work any better than the P/E 1 going forward, you're likely overvaluing it.
I don't expect anything. I was just curious. It would take a lot of evidence to convince me that any of this predictive stuff has any actionable value... Still, I am curious!
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learning_head
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Re: High P/E = high future returns?

Post by learning_head »

garlandwhizzer wrote:I think PEs have reliable predictive value when they reach very extreme levels either low or high. Extreme PEs directly reflect extreme investor sentiment levels, either pervasive panic or euphoria which is what drives net buying or selling of stocks and therefore PEs. Lowest PEs occur when all hope has finally been abandoned, i.e.2008-9 ...
Data in the OP suggests the opposite actually - 2009 had the highest PE, not the lowest... 2nd highest was 2002 - in the depths of that recession... again contrary to what you would expect... ?
garlandwhizzer
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Re: High P/E = high future returns?

Post by garlandwhizzer »

learning_head wrote:Data in the OP suggests the opposite actually - 2009 had the highest PE, not the lowest... 2nd highest was 2002 - in the depths of that recession... again contrary to what you would expect... ?
Thanks for the correction. The exaggerated PEs of 2002 and 2009 were due not to euphoria but to a severe collapse of earnings during a recession. Earnings were hugely impacted by massive write-downs especially in 2009 but also in 2002. When you're in mid or late recession, PEs can be artificially distorted for short periods of time and apparently become opposite indicators due to these distortions. I guess that high PEs have to be in line with exaggerated optimistic investor sentiment in order to be good indicators that it's time to worry. During recessions PEs may spike briefly but in that case sentiment is extremely pessimistic. Excessive investor sentiment--be it optimistic or pessimistic--seems to be the driving force rather than PEs.

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Totoro
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Re: High P/E = high future returns?

Post by Totoro »

garlandwhizzer wrote:The exaggerated PEs of 2002 and 2009 were due not to euphoria but to a severe collapse of earnings during a recession. Earnings were hugely impacted by massive write-downs especially in 2009 but also in 2002. Garland Whizzer
This is spot on. In 2009 virtually every company decided to take as much losses as they could possible get away with. After all, it wasn't their fault, the whole world was falling apart! From a CFO perspective 2009 was a very good year, no blame for crappy performance, clean sheet going forward (unless you were AIG or a major bank).

The effect incidentally is still visible in the Shiller P/E, and I believe is a bit distorted as well as a consequence.
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Re: High P/E = high future returns?

Post by bhsince87 »

IMO, P/E's make a lot more sense when analyzing individual stocks.

Only at the extremes do they make much sense as an indicator with an index.
"If ye love wealth better than liberty, the tranquility of servitude better than the animating contest of freedom, go home from us in peace." Samuel Adams
sciencenerd
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Re: High P/E = high future returns?

Post by sciencenerd »

This is a very interesting topic. Here are my thoughts on the reasons for the unexpected correlation:

1) There is a temporal disconnect between price and earnings, at least in the short term.
2) When stocks are already valued highly, mass psychology makes it easier to invest.
3) Stocks usually spend a lot more time going up than going down. Thus, any valuation metric averaged over time will predict that, most times, valuations will be higher in the future.

How would the same analysis look like for P/E10?
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JoMoney
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Re: High P/E = high future returns?

Post by JoMoney »

Makes sense. The market theoretically should be pricing future earnings discounted back to today. If growth is expected, then higher P/E might be justified, if slow or negative growth expected then a lower relative P/E. The problem is that it's just the best guess of the market, and when the times come that an estimate is wrong and the earnings growth don't materialize, the upset can be particularly devastating when the expectations are too high.
Rick Ferri wrote:Image
Source: Rick Ferri, data from Shiller, plot created by Rick Ferri. Data set is from 1881-2013.
...
An R-squared of 34% implies that about one-third of three-year forward real earnings growth can be attributed to the current P/E ratio. Thus, a higher P/E implies to some extent that higher earnings are coming, and consequently, a higher valuation on the stock market is warranted.
...
Look at the full article for the whole picture of Rick's take on P/E though: http://www.forbes.com/sites/rickferri/2 ... -earnings/
"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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