Monday, January 24, 2011

PE10 Weaknesses

The PE10 is increasingly becoming a common method for value investors to determine whether the broader market is cheap or expensive. Not only does this method have a logical appeal to it, but data suggests that the magnitude of the market's subsequent 10-year returns is related to its PE10 level.

But while there is a relationship between a market's PE10 level and its future returns, the following chart (courtesy of My Money Blog) illustrates that the relationship is rather approximate:

pe10 vs returns.gif

For example, in both 1902 and 1965, the PE10 stood around 23, which is near the PE10 level today. But in the ten years following 1902, the market's real return was 50%, while in the ten years following 1965, the market shrank by almost that much!

Why is there such wide divergence between the market's relative price level and its long-term returns? I would argue that part of the reason has to do with the arbitrary 10-year time period inherent in the PE10 calculation. What you actually want in the denominator of the P/E calculation is a normalized earnings number. Sometimes the E10 (the average earnings of the last ten years) does give you a good approximation for that figure. But other times, such as today, it may not.

For example, in many E10 periods, one recession and one market expansion occurs. These periods may result in an E10 that closely approximates a normalized earnings number. Today, however, two recessionary periods (2001-2 and 2008-9) are contained in the last ten years. I would argue that this arbitrarily biases the PE10 upwards, since the denominator of the PE10 includes only one economic peak period but two economic troughs.

If you throw out the 2001-2 period in the PE10 calculation (so more like a PE8), you get a ratio of about 20.7, compared to the headline number of 23.5, a 15% difference. The data used to create the PE10 is made freely available by Robert Shiller, and you can play with it yourself by downloading it here.


tscott said...

What about the fact that corporate profit margins are far higher than normal. A mean reversion or 'normalized number' would raise the ratio.

the_obtuse_investor said...

Good post Saj.

Even if we use today's PE8 of 20.7, it would be a 26.2% above the long term average PE10 of 16.39. Furthermore, 20.7 would be a 31.2% above the long term median PE10 of 15.77.

In any case, current valuations, PE10 or PE8 are well above the historical average. Valuations like these have, more often than not, led to mean reversions.

Saj Karsan said...

Hi Trevor,

If your argument is that margins in the last ten years are higher than they have been historically, then I would agree with you. If you are saying that margins are higher this year than they have been in past years, then I would say the "averaging" takes care of that.

Hi obtuse,

I agree, 20 is still high, and above the historical average.

Walter said...

I think another important thing to consider is the amount of reinvestment companies are making compared to historically. Companies are paying out much lower dividends as a percentage of income, instead reinvesting the cash, so their earnings should grow faster. Not arguing whether this is more beneficial to shareholders... might be growth without value creation, but the investment and growth happened nonetheless. PE10 downplays the higher rate of change in earnings power compared to 10 years ago.

Saj Karsan said...

Hi walterlu,

I completely agree. I have a post coming out soon on a topic very much related to this.