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How the Market Works

The Danger of High P/E Ratios

Posted by kdadmin on November 14th, 2017.

The Danger of High P/E Ratios

You’ve likely heard the phrase “Price to Earnings Ratio” or “P/E” for short. If you look at the chart above, you’ll notice that P/E ratios have only been as high as they are now at two other times in history. What does the pattern tell you?

Definitions

Let’s backup for a little Investing 101. The phrase, “Price to Earnings Ratio,” or “P/E” for short, refers the price of a stock divided by the profits (earnings) per share of stock. In other words, if a stock that is trading for $50/share has earnings of $2.5/share, it has a P/E of 20. ($50 / $2.50 = 20).

More importantly, knowing the P/E means you can calculate the yield, or return, on this particular stock. If you can figure out the return on a share of stock, you can determine whether that return is better or worse than the return on another sort of investment, like a corporate or treasury bond, a CD, or even a piece of real estate. In order to calculate the yield on a stock, you simply divide the number 1 by the P/E ratio. In this case that would be 1 / 20 = 5%.

Of course comparing returns means you must compare the risk of loss of each investment as well. I’ll cover this in more detail elsewhere, but suffice it to say that risk is measured by something called “Standard Deviation,” and can be easily quantified by individual investment.

Let’s Think About This

Math would tell you that to get the best bang for your investing buck, you would want to buy stocks when P/E ratios were low. If you bought stocks when P/E ratios were 8, then it only costs you $8 to receive $1 in yield, which represents a 12.5% return (1/8 = 12.5%). On the other hand, if you bought stocks when P/E ratios were 50, then it would cost you a whopping $50 to receive $1 in yield, which represents a 2% return (1/50 = 2%).

Now, if we look at the historical risk of loss experienced in stocks, it is possible to lose 50% or more of your investment capital in a market downturn, especially when the market is at a long term high like it is today. But investment grade corporate bonds, on the other hand, the risk of loss is generally much lower, say around 12% during unfavorable conditions.

Price/Earnings RatioS Today

Today, the P/E of the S&P 500 is about 31. If we calculate the yield (1/31), we get a yield of 3.22%.

If we look at the chart above, we can see that a P/E of 31 puts the price of stocks at the second highest point in history, relative to their earnings. We can also see that each each of the other two times that P/E ratios exceeded 30, stock prices plummeted very shortly thereafter. This is how the market works. Here’s why.

If the stock market has a P/E ratio of 31, and can therefore only offer a yield of 3.22%, but poses a risk of losing 50% of my money, Investors are unlikely to think the return is worth the risk. Would you? If, on the other hand, the bond market is offering a yield of 5%, but poses a risk of losing just 12% of my money, most investors are going to think the bond market offers a much better risk/reward ratio. Wouldn’t you?

Here’s the Rub

When Trump was elected in 2016, the stock market’s P/E ratio was 29. In spite of that, the stock market has gone up significantly since then. Is this because the stocks are more valuable? No. It’s simply because some people are willing to pay higher prices.

Think of the housing booms in Florida, Nevada, California and other places around the country in past years. What did we see happen? When an area became perceived as “hot” as more and more people bought houses, prices drastically escalated, but that didn’t mean that the same three bedroom house was actually worth more, just that people were making the emotional decision to buy at higher prices. What happened after each of these housing booms? That’s right, a bust. When the boom was over, prices dropped substantially, and quickly, until they stabilized at much lower prices consistent with their internal values.

Crystal Ball

Buying into a stock market with P/E ratios near all time highs affords little upside value. Maybe stocks will continue to rise a little bit more, but that’s not becausethey have significantly more internal value. As you’ve seen in my previous posts, there are significant, long term, market wide headwinds facing the stock market now.

This is about the time that inexperienced investors chime in and offer pithy advice like, “just hold until the top, then sell.” The problem with this strategy is that, especially in a crazy market, nobody knows where the top is going to be. It’s a little like suggesting you drive on a curvy road at night with your lights off. You’ll be fine for awhile. Until you’re not.

Of course, nobody can consistently predict the future. But simple math tells me that if the stock market has a P/E of 29, then its yield is only 3.4%. If I have to face a potential 50% loss to get that 3.4%, I’m simply not going to do it. I would rather wait for the next time that P/E ratios are down near 12 or 15 (like they were in 2008) before I buy in again.

Why You Care

Warren Buffet has often been quoted as having only two rules of investing.

  1. Don’t lose money.
  2. See rule #1.

Humor aside, math tells us that it takes much higher returns to overcome a substantial loss. For example, if you have $100, and lose 50% in a market crash, you will be left with just $50. But in order to grow that $50 back to $100, you will have to earn 100% to get there, as a 50% return would leave you with only $75.

If, on the other hand, you started with $100, and lost 12% in a market downturn, you would be left with $88, which is a much easier spot from which to recover. If you simply made back the same 12% return, within just one year, you could be back at $99.

In other words, it’s impossible to never lose money while investing, but knowing when to reduce your risk (high P/E ratios), and thereby limit your losses, can put you in a very enviable, and more easily recoverable, place during a market correction. After all, successfully weathering a market correction is a critical part of being able to continue to Live the Life You Love.

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