The price-to-earnings (P/E) ratio is the most basic and most popular measure of value in the stock market.
So, it’s a big deal when a Wall Street expert argues that the way we’ve been interpreting the P/E is wrong.
For the S&P 500 (^GSPC), you calculate the P/E by taking the price of the index and then dividing it by earnings. If the P/E is above the long-run average, then you could argue that the market is expensive. If it’s below, then you could argue the market is cheap. Importantly, prices don’t necessarily have to fall for the P/E to fall; they just have to rise at a slower pace than earnings.
"Contrary to popular commentary"
One the more important and widely-accepted truisms about the P/E ratio is that it has a tendency to revert to its average.
But Wells Fargo’s John Silvia dares to dispute that almost sacred principle.
“Contrary to popular commentary, the S&P 500 price-to-earnings ratio is not mean reverting,” Silvia said on Thursday.
That statement is pretty troubling. And surely, many will argue that it’s an exaggeration if not outright wrong.
However, Silvia’s point is a bit nuanced.
“Yes, you can calculate an average P/E ratio, but you can calculate an average for any time series,” he added. “There is little statistical evidence that the P/E ratio returns to an average value.”
For Silvia, it’s a mistake to assume that the long-run mean P/E acts like gravity in the market.
“The long cycles we see in the P/E ratio are driven by economic factors,” he continued. “During the 1970s, the upswing of inflation and interest rates, along with the uncertainty of oil shocks and recessions, surprised equity markets and led to a downshift in the P/E ratio. In contrast, the steady decline of both interest rates and inflation in the 1980s led to an increase in P/E ratios. Empirically, there are structural breaks in the P/E series—downward shift in October 1987 and again in December 2009, to name a few. In between, there is a shift upward in December 1991.”
What makes a good equity strategist?
The movement of the P/E ratio, which is referred to informally as the market multiple, is chaotic. And it’s almost impossible to predict.
"Only the hubristic deign to project the market multiple,” Morgan Stanley equity strategist Adam Parker once said.
One of the more humble strategists on Wall Street, Parker constantly warns his clients that it can be a money-losing business to make trades based on short-term expectations of the P/E.
But his recognition of this futile exercise and his humility in the face of the market is arguably what makes Parker good at what he does. Silvia might argue as much.
“The S&P 500 P/E ratio is not stationary and not mean reverting and, therefore, any analysis utilizing data since 1982 must recognize that fact,” Silvia said. “Hence, this introduces the role and illustrates the potential value of a good equity market strategist.”
Indeed, developing equity strategy is as much an art as it is a science.
For what it’s worth, the trailing P/E ratio for the S&P 500 is currently about 18, which is above its 10-year average of about 15.