The Streak is Over

The consecutive streak of the stock market not falling more than -1% ended on Tuesday. You have to go back all the way to 1995 for a time when the Standard & Poor’s 500 stock index had not fallen for 1% in 110 consecutive days.

According to data from FactSet, during this period, the trailing 12-month P/E ratio widened from 19.8 to 21.8. The 10-year average P/E ratio is 16.5. For those of you who don’t understand the importance of the P/E ratio, here is a crash course.

The price-to-earnings ratio is the most important fundamental ratio in investing. It is also the most misunderstood. The P/E ratio represents how much an investor is willing to pay for each dollar of a company’s earnings. If a company is expected to grow earnings, the P/E ratio tends to be higher. For instance, if investors are expecting a huge tax cut, then they will pay more for a dollar of future earnings. Therefore, the forward 12-month P/E ratio is more important than the trailing 12-month P/E ratio. The current forward 12-month P/E ratio is at a lower 17.8.

If we fast forward a year, and the new trailing 12-month ratio is at 17.8, then the investors forecast will have been correct today that corporate profits would grow over 10%. In this example where P/E ratios have fallen because of high earnings, then stocks are not overvalued. If the tax cut doesn’t occur in the next few years, there is a good chance I’lll be writing about a new streak of consecutive down days of over 1%!

The inverse of the P/E ratio, or E/P ratio is called earnings yield. The earnings yield helps investors compare the earnings yield of stocks to the interest rates of bonds. The rule of thumb is you buy stocks when the earnings yield of the S&P 500 stocks is higher than the yield on the 10-year Treasury bond. When the 10-year Treasury yield is higher than the yield on the S&P 500 then the market is overvalued. This is the reason why Warren Buffett commented last month that he is not worried about market valuations, but prefaced, as long as interest rates remain low.

The biggest drawback to the P/E ratio is that corporate CEO’s and CFO’s can manipulate earnings through accounting shenanigans. However, they have a harder time manipulating cash flows. This makes analyzing cash flows far superior to the trailing 12-month P/E ratio. A skilled analyst will verify cash flows vs. earnings. If earnings quality is good then cash flows tend be more consistent over time. There are entire textbooks dedicated to explaining free cash flow (FCF) yield. Warren Buffett built his entire fortune on the mastery of this calculation.

It was no coincidence to me that the consecutive streak for no -1% moves ended this week as politicians struggled to pass a new health care reform. Investors are more focused on tax cuts. Fear is beginning to creep into that market that Republicans will not even be able to agree on reforming the tax code. Over the coming months, the breaking news out of Washington will continue to create every twist and turn in the market.

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