Whither the P/E?

Why is the P/E Ratio so darned high? That’s a question that’s bedeviled analysts for many years, not just now.

As a stock-picker, I generally avoid such arguments. The stock market doesn’t need to “make sense.” The market gods have their reasons for doing whatever it is they do, even if it’s not entirely clear to us mortals. The judgments of the markets are true and righteous altogether.

The market’s sanity has especially been called into question lately because the market has done well even though the economy has not. The disconnect between Wall Street and Main Street has become a popular talking point.

As I’ve noted before, this disconnect should not alarm anyone. The stock market and economy have little reason to be strongly linked in the near term. We’ve experienced many such disconnects. One popular idea is that President Trump and, of course, “his cronies” are propping up the market for the election. I’m curious where this cabal was during February and March.

In any event, Alan Reynolds, a senior fellow at the Cato Institute, is the latest to take on this question. I should add that since Dow 36,000, conservative pundits have not had a particularly stellar track record in discussing market valuations. (By the way, here’s a brilliant critique of Dow 36,000 written by, as it turns out, me.)

Reynolds writes:

The argument for stocks being greatly “overvalued” rests on the fact that the trailing P/E ratio rose significantly from May 1 to September 1. On January 1, the P/E ratio was 24.21 –about the same as two years before (24.87). Even after Covid-19 and lockdowns crushed the economy, the P/E ratio was still 23.74 on April 1. Stock prices and earnings had both collapsed in sync. The P/E ratio was 25.10 on May 1 after the Fed funds rate fell to nil and the $1,200 checks and PPP loans peaked. It then rose to 26.69 on June 1, 27.57 on July 1, 28.31 on August 1 and 30.32 on September 1.

First, Reynolds points out that the inverse of the P/E Ratio, earnings over price, should generally follow bond yields. As bond yields have plunged, valuation should rise. Since the days of Alan Greenspan, this has often been called the Fed Model, though Reynolds believes he may have originally influenced the Maestro. They worked together on Reagan’s transition team.

Here’s a chart from Reynolds’s post:

Yes, they certainly do seem to match up. Reynolds also notes that the P/E Ratio falls when inflation rises. Therefore, he claims that Jerome Powell’s Jackson Hole speech, which outlined the Fed’s greater tolerance for inflation, could have been a negative for share prices.

While Reynolds says the lower bond yields justify the higher equity valuations, he says the Federal Reserve deserves zero credit since they were a laggard on lowering short-term rates.

The Federal Reserve can certainly crash the market (e.g., the double-dip recessions of 1980-82), but milder forms of Fed activism rarely explain bond yields or stock prices. The 10-year bond yield has at times risen 3.5 to 4 percentage points above the Fed funds rate, as in 1992, 2001-04 and 2010. Also, the S&P 500 stock index hovered at or below 2000 the last time the Fed kept the funds rate near zero in 2014-15, then rose 46% by July 2019 even as the Fed raised the funds target ten times to 2.5%.

Reynolds then gets to the key point that trailing P/E Ratios are higher but forward ratios may not be. We still don’t know.

I believe Reynolds errs on two key points. One oversight is noting which stocks are rising. There’s a tendency to treat the S&P 500 as if it’s one giant stock. It’s not. The Big Outside of a small group of tech stocks, the stock rally hasn’t been particularly impressive.

Here’s the S&P 500 Tech Index (red) along with the S&P 500 except tech (in blue).

The other point is dividends which are a key component of stock returns. On this point, short-term rates from the Fed have an impact though it’s a limited effect.

Posted by on September 8th, 2020 at 11:54 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.