For some reason President Reagan’s former budget director has an issue with the Russell 2000 small cap index “stratospheric” price-to-earnings (PE) ratio. David Stockman writes that the “actual” PE of the index that holds the 2000 smallest US listed companies is around 91 times earnings. It was hitting an epic 142 at the end of January by some reports.
I add “actual” because the reported PE ratio is currently an acceptable, everything-is-fine 21 as calculated by the index and passed on to investors by the ETFs and mutual funds that follow it.
Okay, there is a minor discrepancy here between 21 and 91. David just needs to accept the “everything is fine” narrative that is important to keep everyone from selling.
Stop rocking the boat David!
The smart investors will need time to exit the casino before the masses know there is a fire.
So why the discrepancy?
Easy. The index simply does not count negative earnings, only positive. That is how most PE ratios are reported today. No bad stuff included in La-La land. It’s kind of like all those reoccurring “one-time” expenses companies leave out of their earnings statements.
I’ll admit I had a hard time accepting the PE of 91. It just seems too fantastic. So I did a little exercise. I looked at the 10 largest companies by market value in the TSP S fund (VXF ETF). Here are the numbers from this small sample.
- $331 Billion in Market Cap (1% of total US)
- Price-to-Sales (PS) ratio = 3.5 ($94 Billion in Revenue)
- Price-to-Earnings (PE) = 165 ($2 Billion in Net Income)
For reference the 1950-1995 average ratios for the SP500 were PS < 1.0 and PE < 15.
Using the same 10 companies, I eliminated the six with negative income. Yes, six. And came up with:
- $154 Billion in Market Cap
- Price-to-Sales (PS) ratio = 2.6 ($60 Billion in Revenue)
- Price-to-Earnings (PE) = 19 ($8.1 Billion in Net Income)
Yeah, 19 looks better than 165! And this is why it is reported to you.
My verdict on PEs
Earnings make a lousy measure of valuations. Not only are they easily and often manipulated by companies, a few big losers can really skew the ratios. Both the PE of 19 and the PE of 165 are bad yardsticks to measure valuations. Price-to-Sales are better since revenue is revenue and it is a more stable factor.
While I do not know the historical average for the smallest 2000 stocks, I know a SP500 Price-to-Sales ratio of 1.0 is a good rule-of-thumb for valuations. Applying this yardstick to the TSP S fund’s top ten, I would say they are 3(ish) times historical valuations. And yes, that still qualifies as “stratospheric”.
One of my broken records is that we can’t time markets using valuations levels. We would miss most of the gains of the last 3 bull markets. But we can gauge future returns based on where valuations are today. Higher valuations, mean lower future returns.
What about the SP500 (TSP C fund)
In the next chart, I have added a couple of lines showing where the SP500 would be if it reverted to a Price-to-Sales of 1.0 (Blue). I also added an average Shiller PE valuation (Red) which uses a running 10-year average earnings of the SP500 index to smooth out the earnings cycle.
We see why you can not time the market based on valuations. The SP500 is a tad (cough, cough) over its historical valuations.
Thanks central banks.
The down arrow is not an imminent prediction. It just shows if the SP500 lost 50% it would be back to average price levels.
Regardless of how it plays out, you can not get historically average returns of 8% annually from the SP500 going forward until valuations reset. To return to this level, the market’s total return needs to remain zero for 10 years with 2% GDP growth. If history repeats, we will see another run-of-the-mill bear market with 50% losses and then 100% gains to end back to today’s price levels in 10 years.
I expect this and plan to send alerts out as necessary.
Contrast this to what Business Insider tells us about how Morgan Stanley is preparing their robo advisers to send out calming email messages that “appear like a human wrote them” to tell everyone to not panic and hold when the markets go haywire.
Don’t go it alone.
Our goal is to capture most of the bull markets gains and avoid the most to the bear market losses. In other words, focus on the big picture and what drives the market with strategies that work in both up and down markets. It can be done with few allocation changes.
Robos need not apply.