P/E Ratios Say No Gains...For Years?!!
When P/E ratios decline, that means gains will be flat to negative in stocks in the future. P/E ratios are declining. Yes I realize the stock market's been on an upswing, even within 10% of its all-time high. But even if that continues for a while, please follow along here. You'll see why it's important to understand the difference between "low" and "declining" PE ratios.
If you say that today's lower P/E ratios indicate that stocks can be bought at good values, you might be right. But you have to get beyond "low." For example, some P/Es are low. But what you want to know is not just that they're low, but that they are, in fact, declining. The difference here is one of movement or direction. Right now the direction - or trend - is down.
If P/E ratios are already low - one indicator that stocks are cheap - and they begin to rise, that's a good sign. Again, we're looking at movement or direction. If they were to continue to rise - a characteristic of a bull market in stocks - then you'll have long-term gains in stocks. (By long-term, you can figure on, let's say, 10 years or so, but that's not a rule, just an estimate. You have to look at other factors to get a better idea of how long gains may last.)
Of course, when you reverse that - with P/E ratios either high or even if they're not that high, but they're in a declining pattern - that's a characteristic of a bear market in stocks.
Since they are, in fact, declining - and have been pretty consistently since 2000 - it's a good bet we're in a bear market in stocks. Indeed, we've been in a secular bear market. ("Secular" means longer-term than "cyclical.")
If you think about it, this is simply common sense. If P/E ratios are declining, it means that the price of a stock relative to its earnings in heading down. (P = price of the stock; E = earnings.)
When the price of a company's stock declines relative to the earnings of the company, it tells us that more people are selling the stock than buying it. That's why the price is going down - more sellers than buyers.
Why would people sell a stock whose price is getting lower relative to earnings? Shouldn't that indicate that the stock is a better value - i.e., that's it's not overpriced? You could guess that perhaps this is the case. But the better guess is that the price is going down because the price was probably too high to begin with.
The thing about trends is that it's usually tough to fight them. And if we look at the situation with declining P/Es, I think you can see that as long as the trend continues down, you're better off not making wild guesses. Just respect the trend and don't plunk a ton of cash into stocks when the P/Es are declining.
There are exceptions to all this. Some people have a special expertise at "picking" stocks even when the trend of P/Es is down on a general basis. But unless you have that special skill, you'd be a fool to buy into this declining pattern.
In any case, right now P/E ratios are indeed declining in the stock market in general. If you have a good asset allocation that you're happy with, this doesn't mean to run out and sell all your stocks. But it probably does mean that you wouldn't want to put extra gobs of cash into stocks. Stick with your allocation if it makes sense to you. But don't bet on stocks going up in the longer term when P/E ratios are in a declining pattern.
You can find a lot more out about rising and falling trends in P/E ratios and their ability to predict future stock prices by going to the Crestmont Research website. I've learned a lot from Ed Easterling and his website. He's incorporated his research in some books as well. You'll find his books advertised on the website.
If you say that today's lower P/E ratios indicate that stocks can be bought at good values, you might be right. But you have to get beyond "low." For example, some P/Es are low. But what you want to know is not just that they're low, but that they are, in fact, declining. The difference here is one of movement or direction. Right now the direction - or trend - is down.
If P/E ratios are already low - one indicator that stocks are cheap - and they begin to rise, that's a good sign. Again, we're looking at movement or direction. If they were to continue to rise - a characteristic of a bull market in stocks - then you'll have long-term gains in stocks. (By long-term, you can figure on, let's say, 10 years or so, but that's not a rule, just an estimate. You have to look at other factors to get a better idea of how long gains may last.)
Of course, when you reverse that - with P/E ratios either high or even if they're not that high, but they're in a declining pattern - that's a characteristic of a bear market in stocks.
Since they are, in fact, declining - and have been pretty consistently since 2000 - it's a good bet we're in a bear market in stocks. Indeed, we've been in a secular bear market. ("Secular" means longer-term than "cyclical.")
If you think about it, this is simply common sense. If P/E ratios are declining, it means that the price of a stock relative to its earnings in heading down. (P = price of the stock; E = earnings.)
When the price of a company's stock declines relative to the earnings of the company, it tells us that more people are selling the stock than buying it. That's why the price is going down - more sellers than buyers.
Why would people sell a stock whose price is getting lower relative to earnings? Shouldn't that indicate that the stock is a better value - i.e., that's it's not overpriced? You could guess that perhaps this is the case. But the better guess is that the price is going down because the price was probably too high to begin with.
The thing about trends is that it's usually tough to fight them. And if we look at the situation with declining P/Es, I think you can see that as long as the trend continues down, you're better off not making wild guesses. Just respect the trend and don't plunk a ton of cash into stocks when the P/Es are declining.
There are exceptions to all this. Some people have a special expertise at "picking" stocks even when the trend of P/Es is down on a general basis. But unless you have that special skill, you'd be a fool to buy into this declining pattern.
In any case, right now P/E ratios are indeed declining in the stock market in general. If you have a good asset allocation that you're happy with, this doesn't mean to run out and sell all your stocks. But it probably does mean that you wouldn't want to put extra gobs of cash into stocks. Stick with your allocation if it makes sense to you. But don't bet on stocks going up in the longer term when P/E ratios are in a declining pattern.
You can find a lot more out about rising and falling trends in P/E ratios and their ability to predict future stock prices by going to the Crestmont Research website. I've learned a lot from Ed Easterling and his website. He's incorporated his research in some books as well. You'll find his books advertised on the website.
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