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The Fallacy of Low P/E Ratios

Posted
12/30/2013 2:50:00 PM
By: ETFguide
Referenced Stocks:

What's is the S&P 500's real price-to-earnings (P/E) ratio anyway?

Tune into one media outlet and they claim, "The S&P only has a P/E of 16.2x".

Another money manager states the "P/E is 17.0x".

Still others suggest the P/E is currently at 17.8x.

What if I were to tell you all of these P/E's are wrong and have never even existed?

Valuation Tricks and the Real P/E
In reality, the S&P 500 (NYSEARCA:SPY) would have a P/E of 16.2x if the expected 2014 operating earnings of $111/share comes to fruition around February 2015. That's a very long 14 months from now and the likelihood of earnings expectations remaining this lofty based on recent history is slim to none (see graphic below).

Likewise, the stock market (NYSEARCA:SSO) will only have a P/E of 17.0x if the expected 2014 reported earnings target of $106/share is met around the same time in early 2015.  In other words, estimates for the future.

Furthermore, the market has a P/E of 17.8x given the latest quarter's actual earnings (finalized by December) but at September's S&P price.  When the S&P (SNP:^GSPC) was at 1,682 at the end of the 3Q, earnings were still expected to come in higher than they actually did, making the P/E actually  higher than expected then.

The real P/E today is currently 19.5x, based on actual earnings through the 3Q 2013 reporting period and 12/27's S&P 500 price, but what does it matter anyways?

Earnings haven't mattered for three years as the charts below show.  Earnings have been missing, quarter after quarter, yet the market still goes higher, rising due to multiple expansion instead of growing because of fundamentals.  One must question the validity of earnings to justify the current market environment.


The first chart in the next graphic below was also highlighted during the summer as a trend that was likely to end.  Also from Standard and Poor's, just as they were in 2012 and 2013, CEOs and analysts overestimated earnings, just long enough to convince investors that P/E ratios would still be low, in the mid-teens.  2014's earnings have now joined 2012 and 2013 by lowering guidance throughout the year.

If this continues and at current equity prices, by the time mid-2014 arrives P/E ratios will be nearer the current 19x level than the 16x level currently being promoted. 



Earnings Games
The mainstream media and talking heads like to play games when it comes to stock market valuations.  Distorting reality gives a better view of market valuations. And since most experts rely on ever higher stock prices to make their livings, their biases keep the greater fool theory alive.

In July I wrote an article suggesting you should ignore Wall Street's earnings estimates and look solely at actual results because basically Wall Street has no clue when it comes to estimating them anyways. 

Take a look at the first set of charts above, from Standard and Poor's, which show the consensus earnings estimate histories of 2012 and Q4 2013 by analysts.  These charts were first highlighted in my July article entitled, " Why you Should Ignore Wall Street's Earnings Estimates " with the right graphic showing that 4Q 2013 has continued the downward guidance trend, now 10% lower than was expected and sold to the public last year.

What to Do?
If you bought equities because of earnings and expected profits to grow into your P/E your strategy has not worked. Then again, sometimes it's better to be lucky than good as the market has still provided positive returns for you.

But how long will the market's disconnect with stagnant fundamentals last?  History suggests the markets move in valuation cycles, often with very large swings.

Combining other indicators such as technicals and sentiment along with the fundamentals can often give a better overall picture of the markets, allowing you to focus on what really matters at that point in time. This allows you to take advantage of the strategies that are currently working and to be ready when the trend does finally change.

Using some of these technical and sentiment indicators helped us get long the homebuilders (NYSEARCA:XHB) 12/18 when we suggested in our 12/16 ETF Profit Strategy Newsletter for traders to buy ITB (NYSEARCA:ITB) when it was at $23.50.  Already the trade is up over 4%.  Stops have been moved up to breakeven, allowing investors to now play with the house's money. 

Following earnings and fundamentals at a time when they simply aren't important to the markets means other strategies should be utilized.  As earnings continue to disappoint, and in the case of the homebuilders, data continues to be mixed, this will only become more a necessity as other strategies continue to provide results that more traditional methods do not.

The ETF Profit Strategy Newsletter , which includes our Technical Forecast and Weekly ETF Picks, uses technical, fundamental, and sentiment analysis to be on the right side of the market.

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