Home Value Investing Does P/E10 Do a Better Job of Making Return Predictions When Valuations Are at Extreme Levels?

Does P/E10 Do a Better Job of Making Return Predictions When Valuations Are at Extreme Levels?

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Valuation-Informed Indexing #158

by Rob Bennett

There are not too many knowledgeable people who deny anymore that there is a strong correlation between the P/E10 level that applies when a stock purchase is made and the long-term return that is obtained on that stock purchase. I have been promoting the Valuation-Informed Indexing concept since 2002 and this is one area in which I have seen a significant change in both expert and investor opinions. In the old days, I often heard the argument made that the very idea that returns could be predicted effectively was loony tunes. That’s not so today. Today just about everyone will say that there is at least some correlation and most will say that the correlation is at times strong.

That said, foot-dragging remains a reality. People acknowledge that there’s a correlation. But most experts and most ordinary investors still possess a desire to minimize the the importance of the correlation to the extent possible.

One common approach to doing this is to argue that the P/E10 value matters at the extremes only. The P/E10 value stood at 44 in January 2000. Some will say: “There really was a problem at the top of the bubble. When the P/E10 level is as high as it was in January 2000, it’s a good idea to lower your stock allocation a bit.” The “but” either follows or is implied. The “but” is: “As a general principle, however, you don’t need to worry about this P/E10 nonsense.”

No.

P/E10 always matters.

It always matters a lot.

I need to start by acknowledging that there is some truth to the claim that P/E10 matters most when valuations are at extreme levels. That P/E10 value of 44 brought on an economic crisis. When valuations get that high, the P/E10 number is telling us a lot more than just that stock returns will be poor for some time to come. It is telling us that we are in store for a price crash big enough to cause hundreds of thousands of businesses to fail and millions of workers to lose their jobs. When we see a P/E10 value of the type we saw in the late 1990s and in the early- and mid-2000s, we should know that we are entering not only financially troubling days but economically troubling days and even politically troubling days as well.

That said, it is a mistake to view P/E10 as something you take into consideration only when prices reach insanely high levels.

The P/E10 number is the price-tag of stocks. You look at P/E10 to identify what sort of value proposition is being offered by a stock purchase. No one would say that you should inquire of a used-car dealer the price he is asking for a car only when he is asking three times the fair value of the car. You ALWAYS want to know what price it is you are paying for a car. So it should be with stocks. You cannot make an informed decision about any stock purchase without knowing the price that applies. P/E10 always matters.

Say that you go with a 70 percent stock allocation at times when prices are not extreme. And say that the P/E10 level drops to below 12. At that price level, stocks offer not only a strong long-term value proposition but an amazing one. Doesn’t that matter?

If you go with a stock allocation of 70 percent when the P/E10 level is 19 or 17 or 15, logic demands that you go with a stock allocation of something greater than that 70 percent when the P/E10 level is 11 or 9 or 7. There are many investors who resist this idea. They say “A 90 percent stock allocation is just too darn risky. I cannot go there.”

Each investor has to make his own choices, to be sure. But this attitude just does not make sense if you believe, as Shiller’s research demonstrated many years ago, that valuations affect long-term returns. The odds that you will see a poor long-term stock return on a purchase made at 7 or 9 or 11 just are not the same as the odds that you will see a poor long-term stock return on a purchase made at 15 or 17 or 19. The riskiness of stocks diminishes as the P/E10 level drops. So, if you could bear to take on the risk associated with a 70 percent stock allocation when the P/E10 was 15 or 17 or 19, then you can bear to take on the risk associated with an 80 percent or 90 percent stock allocation when the P/E10 is 11 or 9 or 7.

Resistance to this idea is resistance to logic. Many investors don’t like to hear things said so bluntly. But that’s an obvious logical implication of the finding that valuations affect long-term returns. We have in the past 10 years grown more accepting of the idea that valuations matter. As more time passes, I believe that we will become more accepting that valuations matter in all circumstances, not just some.

How about if P/E10 value is in neutral territory, 14 or 15 or 16?

It’s true that in those circumstances you should be going with the stock allocation that makes sense for you on an overall basis. If you are a 70-percent-stock guy or gal, 70 percent stocks is the right choice when stocks are priced at fair-value levels.

The P/E10 value is still telling you something of importance in those circumstances, however.

Say that stock prices begin a run upward following a purchase of an index fund that you make when the P/E10 value is 15. The fact that prices are now heading into overvalued territory tells you something important. It tells you that the gains represented by the climb in P/E10 value above fair value are temporary gains, gains that will be lost in the long run as prices make their inevitable way back to fair-value levels. That’s a very different story than the story that would apply if your purchase had been at a P/E10 level of 8. In that case, you could see very large permanent gains because even large gains would only be pulling prices back to fair-value levels.

The P/E10 metric is a far more powerful tool than most of today’s investors realize. The price you pay for the stocks you acquire ALWAYS matters.

Rob Bennett has recorded a podcast titled Investing News Makes Us Dumb.  His bio is here.

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