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P/E ratios remains well above historical norms


By Mark Hulbert, MarketWatch
Last Update: 12:06 AM ET Dec 9, 2005

ANNANDALE, Va. (MarketWatch) -- They're doing it again.

By "it," I mean that some advisers are playing fast and loose with the historical data to make it appear as though the stock market's price-earnings ratio isn't as above-average as it really is.

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That in essence is the argument made by two hedge fund managers, Clifford Asness of AQR Capital Management, and Anne Casscells of Aetos Capital. In a working paper they wrote in 2004, they argued that many advisers are calculating the market's current P/E ratio one way and then comparing it to an historical average calculated in another way.

I wrote about their argument in January, and reported that, according to an honest apples-to-apples comparison, the market's P/E ratio then was between 46% and 50% higher than the historical average. Read archived column

What does their analysis suggest for today?

The good news is that the market isn't as overvalued today as it was a year ago. The bad news is that it still is significantly overvalued.

But I'm getting ahead of myself.

To understand Asness' and Casscells' argument, consider the following statement. It, or its functional equivalent, is repeated so often by investment newsletters and on Wall Street that we're likely to accept it as a legitimate argument, even though its reasoning is faulty.

The statement goes: "Based on analyst estimates for 2006, earnings on the S&P 500 next year are likely to total $X, which results in a P/E ratio of Y. That's right in line with that ratio's historical average of about 15."

Did you catch the sleight of hand inherent in it?

According to Asness and Casscells, the problem with this reasoning is that it compares a P/E ratio calculated using forward earnings with past P/E ratios calculated using trailing earnings. Since analysts invariably project earnings to grow, P/Es based on forward earnings will always be lower than those based on trailing earnings.

A legitimate historical comparison therefore requires comparing current and past P/Es that are all calculated using trailing earnings - or comparing today's with historical ratios when all are calculated based on forward earnings.

Consider first the ratio calculated using trailing earnings. For the trailing four quarters, according to Standard & Poor's, reported earnings per share for the S&P 500 ($SPX: news) have totaled $67, which results in a current P/E ratio of 18.7. Between 1871 and 2003, according to Asness and Cascells, the median of P/E ratios calculated in this way is 13.7.

Based on trailing earnings, therefore, the stock market's current P/E suggests that the market is 36% overvalued.

Consider next the ratio calculated using forward earnings. According to S&P, analysts are projecting total operating earnings per share for 2006 to be $88.59, which yields a P/E ratio of 14.2. The median of comparably-calculated P/E ratios for the 1871-2003 period is around 11, according to estimates from Asness and Casscells.

So according to this approach to calculating P/E ratios, the market is 29% overvalued.

As I hinted earlier in this column, the only good news implicit in these numbers is that they are not as bad as in January.

The problem with above-average P/E ratios is that they remove one of the strongest foundations that a bull market can otherwise have. That leaves the market particularly vulnerable to shifts in investor psychology.

That's just another way of saying that risk is above average in the market right now.

This doesn't mean that the market must go down. But it does mean that, at a minimum, the market is unlikely to provide high enough returns to adequately compensate investors for the risk they incur by being investing in stocks at current levels.

The most recent edition of the Hulbert Financial Digest is available by e-mail or regular mail. Highlights include:

-- If you think the stock market has gone nowhere since 1999, think again.

-- Scoreboards Performance, most/least popular stocks and funds, market exposure among timers

-- Profiles: Ford Equity Research Investment Review, Investor Advisory Service, Richard E. Band's Profitable Investing and Sound Advice

For more information or to subscribe to the Hulbert Financial Digest, click here


Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

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