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The phrase 'the worst is over' has acted as a crutch for blue chips since late March, and helped facilitate the belief that the Dow has reached a solid bottom. However, has the bottom really arrived?1
1980s Versus Today: Comparing P/E Ratios and Perceptions
While stocks average a P/E ratio of roughly 16 through out history, the Dow currently trades with a P/E average of 29. By comparison, back in 1980 the Dow had a P/E of under 8 before beginning its biggest bull march ever in 1981. The conclusion is that although P/E ratios may be somewhat meaningless and arbitrary, in hindsight the extremes are nearly always predictive of dramatic bull and bear markets.
To claim that high P/E's are the most important statistic Dow investors follow is, of course, silly. For instance, in the early 1980s even as Dow earnings estimates were not met stocks still rose. Meaning that multiples, and stocks prices grew even as the earnings estimates got slashed. As such, could a similar rally unfold today even if current earnings estimates prove insanely high?
The reason why most believe that stocks rallied in the early 1980s was because price/earnings valuations were seen as attractive*, and Paul Volcker had successfully implemented a plan of attack to end the stagflation of the 1970s. By contrast, a different situation could be happening today: price/earnings valuations on the Dow 30 are more than triple levels seen in 1980, and, dependant on which economic numbers you care to focus on, the economic/inflation situation is becoming increasingly worrisome.
To continue the comparison with the 1980s look at those earnings per share estimates made on the Dow 30 at the beginning of 1980 for the period of 1983-1985 versus similar comparisons today. Does this tell us anything?
Value Line Estimates 2 |
1980 EPS Estimates |
Acutal EPS results |
Average P/E Ratio |
for 1983-1985 |
for 1983-1985 |
from 1978-1980 |
|
Acloa |
$7.75 |
$2.27 |
4.5 |
Allied Signal |
7.2 |
4.2 |
7.5 |
American Can |
8.5 |
4.42 |
6.5 |
American Express |
5.64 |
2.96 |
7 |
Bethlehem Steel |
9 |
-4.36 |
5.5 |
Chevron |
10 |
4.76 |
5.7 |
DuPont |
8.7 |
5.13 |
7.5 |
Eastman Kodak |
7.47 |
2.51 |
9.1 |
Exxon |
10 |
6.66 |
6.2 |
General Electric |
5.2 |
4.87 |
8.4 |
General Motors |
13 |
12.78 |
5.3 |
Goodyear |
6.5 |
3.27 |
6.1 |
IBM |
9.9 |
10.16 |
12.3 |
Inco Ltd. |
5.25 |
-1.14 |
14.2 |
International Paper |
9.2 |
3.07 |
6.2 |
McDonald's Corp. |
4.55 |
4.4 |
10.2 |
Merck |
4.6 |
3.4 |
13.6 |
MMM |
9.25 |
5.99 |
10.3 |
Navistar |
13 |
-4.9 |
4.4 |
Owens-Illiniois Glass |
8 |
4.14 |
5 |
Philip Morris |
4.35 |
4.3 |
8.9 |
Proctor & Gamble |
6.53 |
4.7 |
11.6 |
Sears, Roebuck |
4.2 |
3.78 |
8.1 |
Texaco |
9.4 |
4.5 |
5.6 |
Union Carbide |
4.17 |
1.03 |
5.1 |
United Technologies |
5.25 |
4.24 |
7.6 |
U.S. Steel |
8.3 |
-0.52 |
6.7 |
Westinghouse |
3.63 |
3.03 |
5.3 |
Woolworth |
5.75 |
2.28 |
4.5 |
Average |
$7.39 |
$3.51 |
7.54 |
First Call Estimates 3 |
2001 Consensus |
2002 Consensus |
Trailing P/E |
5 Year Divergence %* |
June 13, 2001 |
EPS Est. |
EPS Est |
||
Acloa |
$2.07 |
$2.83 |
22.3 |
-1.10% |
American Express |
2.07 |
2.42 |
20.91 |
-0.7 |
AT&T |
0.22 |
0.36 |
NA |
13.1 |
Boeing |
3.78 |
4.42 |
19.19 |
-11.6 |
Caterpillar |
2.61 |
3.42 |
19.59 |
20.2 |
Citigroup |
3.02 |
3.47 |
19.41 |
-1.4 |
Coke |
1.6 |
1.83 |
36.83 |
11.8 |
Disney |
0.8 |
0.96 |
134.5 |
9.7 |
DuPont |
1.98 |
2.61 |
24.7 |
4.6 |
Eastman Kodak |
3.89 |
4.48 |
11.25 |
3.5 |
Exxon Mobil |
4.99 |
4.46 |
17.9 |
1.6 |
General Electric |
1.47 |
1.7 |
36.61 |
1.3 |
General Motors |
3.78 |
4.62 |
13.58 |
-7.8 |
Hewlett Packard |
1.05 |
1.39 |
24.5 |
5.1 |
Home Depot |
1.25 |
1.51 |
46.04 |
-3.7 |
Honneywell |
2.65 |
3.18 |
28.75 |
3 |
IBM |
4.84 |
5.48 |
25.37 |
1.5 |
Intel |
0.54 |
0.78 |
24.46 |
0.01 |
International Paper |
0.38 |
2.2 |
142.48 |
-2.9 |
Johnson & Johnson |
3.86 |
4.37 |
28.76 |
1.6 |
JP Morgan Chase |
3.06 |
3.98 |
18.07 |
3.8 |
McDonald's Corp. |
1.49 |
1.67 |
21.16 |
4.1 |
Merck |
3.2 |
3.51 |
24.55 |
-2.5 |
Microsoft |
1.8 |
1.94 |
39.27 |
-20 |
MMM |
4.85 |
5.53 |
26.72 |
6.2 |
Philip Morris |
4.08 |
4.61 |
12.53 |
1.4 |
Proctor & Gamble |
3.11 |
3.27 |
24.43 |
0.1 |
SBC Communications |
2.35 |
2.6 |
18.49 |
5.5 |
United Technologies |
4.09 |
4.7 |
21.83 |
-2.9 |
Wal-Mart |
1.54 |
1.76 |
35.47 |
-4.6 |
Average |
$2.55 |
$3.00 |
29.88 |
1.3333% |
Devils advocate: Although there are glaring differences in valuations from 1980 to today this does not tell us much. As well, even if current earnings estimates 5 years out prove too optimistic there is no guarantee that stocks prices will falter. The truth is, to borrow a thought from Buffett, if past history was all there was to the game, the richest people would be librarians.
Therefore, since the stats have been rendered meaningless, perhaps a more appropriate method to rationalize what investors will do going forward (or to speculate) is seen when looking at the contrast in popular perceptions during each respective age:
From August 1979 Business Week: The Death of Equities
The dominate popular commentary on the markets since late March 2001: The Worst Is Over
The Business Week article in question went down in history as one of the worst predictions ever. By comparison the 'worst is over' can be repeated infinitely and sooner or later this adage will be proven correct. The difference being that the worst can only really be over when people are seeing the worst, predicting the worst, and not involved in stocks. Perhaps the most extreme case of this contagion was seen in 1979. Conversely, today people are seeing the best (the rebound!), analysts are predicting the best (earnings!) and nearly everyone (over 50% of Americans!) is involved in stocks. With this in mind, is it surprising to see the Dow Jones Industrial Average trading with near record high premiums?
Quite frankly, historically high P/E ratios (and broader valuations) marked also by overly optimistic EPS estimates threaten to thrash the markets lower and eat unsuspecting investors alive. But the problem is that the earnings, and valuations themselves do little to tell us exactly when this carnage may begin. As such, intensely focus your attention to the adages that comment on the markets. The new slogan to watch out for is 'new lows'. If this perception takes hold the contradiction is easily seen: How can the worst be over if a 'new lows' mantra takes control of the investors mind state?
Only once perceptions surrounding current market conditions begin to change can investors hope to see more attractive valuations.
1. While much of the economic situation continues to display signals of deterioration including retail numbers, the employment situation and capital spending, there have been some faint signals that a rebound is underway. One such signal is the stabilization in consumer confidence in April, and May. However, one could argue that without the stock market rally consumer confidence would not have stabilized. Furthermore, such an argument could put forth that the horrific earnings situation going forward will readily combat recent equity gains, thus striking down consumer confidence yet again. As such, if you take the temporary consumer confidence rebound out of the picture 'the worst is over' ideologies would come under further scrutiny. Perhaps this is beginning to happen right now…
2. Value Line Estimates for 1983-1985 (excluding AT&T) are from Graham and Dodd's Secutiry Analysis
Fifth Edition - Page 522-523
| Security Analysis: The Classic 1934 Edition
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3. First Call estimates, and price-to-earnings data from June 13 market close.
* For an illustration of Price to Earnings patterns see Abby Ignores Ominous P/E Patterns
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