UBS Says Expensive Stocks Are the Cheapest. Wait…What?

Today’s game is called, Spot the Logical Fallacy!

Investors should purchase stocks with the highest price-to-earnings ratios because their valuation premium to the cheapest shares is too low, according to Jonathan Golub at UBS AG.

The gap between the Standard & Poor’s 500 Index industries with the highest and lowest P/Es narrowed to 3.6 last month from 9.6 in 2006, according to UBS, which used projected earnings for its valuations.

The disparity suggests purchasing expensive stocks may boost returns during the next 12 to 24 months, the UBS strategist said. The three industries with the highest multiples in the S&P 500 are industrials, consumer discretionary and consumer staples, according to UBS.

“This is akin to purchasing a Picasso when high-priced artwork is out of favor,” Golub, the New York-based chief U.S. market strategist, said in a telephone interview yesterday. “On a relative basis, cheap stocks are overvalued because they are much closer to the market average. It’s not that I want to overpay for companies, but rather traditionally high P/E stocks are cheaper than they should be.”

Did you find it? The problem is that this argument assumes that all the high-P/E Ratio stocks will stay the same. Even if the thesis is correct, the market may very well choose another cohort of stocks to send to the upper-P/E Ratio bin.

This sloppy thinking happens a lot. Last year, Paul Collier wrote an influential book called The Bottom Billion. In it, he said that the poorest countries in the world regularly fall behind everyone else in terms of growth. Like most tautologies, that statement is true. Poor countries do indeed always fall behind everyone else. That’s why they’re poor.

William Easterly wrote:

Collier selected countries that were on the bottom at the end of a specific period, so naturally they would be more likely to have had among the worst growth rates in the world over the preceding period. This ex post selection bias makes the test of poor-country divergence invalid. The correct test would be to see who is poor at the beginning of the period and then see if they have worse growth than richer countries in the following years. When the test is run this way, there is no evidence that poor countries grow more slowly than richer countries.

Posted by on October 12th, 2010 at 10:32 am


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