On My Radar – A Death Trap – The Problems With Forward PE

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By Harvest Exchange

I was in Denver this week presenting at a large investor forum. I shared with the audience two valuation charts I believe you will find interesting. One looks at forward PE (a measure I disfavor). The other is what Warren Buffett called “probably the best single measure of where valuations stand at any given moment” in a 2001 Fortune Magazine interview.

Often I hear the argument that the market is inexpensively priced at a current PE of just 15. Several readers responded to my recent Forbes piece challenging my view that the market is overvalued. They all pointed to the lower forward PE which is based on Wall Street analyst’s forward estimated earnings. The reason I disfavor forward PE is that Wall Street analysts have a bad habit of consistently missing the mark. The Forbes piece was titled, Stock Market’s High P/E Suggests Lower Returns Ahead.

I wish I had included the following chart in that article. It shows what happened the last time forward PE was north of 15 (as it is today). It was 15.2x at the market peak in October 2007 – a -57% decline followed. It is 15.6 today.

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The simple point is that when you buy in when the market is expensively priced, forward potential return is lower and risk considerably higher. The first bullet in today’s On My Radar shows Buffet’s favorite valuation measure – Stock Market Capitalization as a Percentage of Nominal GDP. It shows a market that is more overvalued today than it was in 2007 or any other period in time dating back to 1925 (with just one exception, March 2000).

Portugal was front and center this week. It remains a debt mess in Europe. Remember Cyprus? The “Cyprus flu” appears to be spreading. The structure is now in place to do the same in Germany. Additionally, the IMF is pushing towards a 10% tax on all household assets to bail out the government. The problem is unmanageable debt.

I share the following in this week’s On My Radar:

  • Stock Market Capitalization as a Percentage of Nominal GDP – Warrant Buffett’s favorite valuation measure
  • Armstrong – Expropriation Is Back – Is Christine Lagarde the Most Dangerous Woman In The World?
  • Germany OKs Plan to Make Creditors Prop up Banks – Think Cyprus
  • From the Bank for International Settlements – An Unusual Warning to the Fed and the Global Central Banks
  • Trade Signals: Risk Remains High – 07-9-2014

Stephen Blumenthal, CMG Capital Management Group: On My Radar – A Death Trap by Harvest

On My Radar: A Death Trap

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