George Bush predicts P/E ratios will rise. Megan McArdle--sensibly--disagrees.
First George:
Bush Defends Treasury Secretary and Speaks Out on Markets
...to the clear distress of some of his aides, Mr. Bush went into an extensive discussion of the falling market, after a reporter asked what would send the market back up. "Value," Mr. Bush said. "They're going to realize that there's values in the market. In other words, if they buy stock, they're buying value, as opposed to buying, you know, buying into a bubble." He said market confidence would increase if Congress passes a corporate accountability bill this week before the House goes into its summer recess. He then returned to his theme, predicting that corporate earnings are bouncing back and stocks won't be far behind.
"What's happening is corporate earnings are improving, so that the price/earnings ratios are improving," Mr. Bush said, referring to the ratio between the price a stock is fetching and a corporation's per-share earnings. "And I believe people are going to come back into the market. But listen, I'm not a stock broker. I'm not a stock picker. My attitude on Wall Street is they'll buy you or sell you, depending upon if it's in their interest."
In defending Mr. O'Neill, Mr. Bush said: "I say he's doing a fine job. And when the market goes up, I hope they will give him credit. If they're going to hold him accountable for a market going down, they ought to give him credit when the market goes up." Relatively few of the criticisms of Mr. O'Neill have focused on the market's decline. Instead, many Wall Street executives and members of Mr. Bush's party have said Mr. O'Neill, former chief executive of Alcoa, has not focused on the right economic issues or inspired confidence in the government's response to economic downturn.
Now Megan:
[Standard Jane rant about equity valuations: Right now, the S&P stands at 32 times earnings. While the P/E ratio usually does rise at the bottom of a recession because earnings are very depressed, this is still nearly 50% higher than the historical highs for S&P P/E's. We used to think that the abnormal ratio meant that the risk premium on equities, the higher rate of return that investors demand on stocks compared to risk-free treasury bills, had gone down. Oops. Turns out that the risk premium was only lower when investors thought that stocks could only go up, or in other words, were mispricing the actual risk. Now it looks like the S&P et. al. have to get back somewhere near that 20 mark for the market to have actually bottomed. Maybe earnings are so depressed, and the risk premium is sufficiently altered, that it will bottom at 25. But probably not at 32. Remember, the spectacular rises before were fueled by everyone pouring all their spare cash into the market. That's not coming back. Even if the market bottoms now, it probably won't go anywhere much for a couple of years yet; people simply are not going to come back at the previous volumes. People are scared, and they're diversifying out of equity. Sensibly so. But it's hard to see how they can support P/E's of 32.]
Posted by DeLong at July 23, 2002 08:46 AM | TrackBack
Doing the math, that puts the Dow at around 5000 before P/E ratios are at 20.
Posted by: etc. on July 23, 2002 11:27 AMI'm impressed. I had a low opinion of Megan (prejudice - she has an MBA from Chicago, and a spinal reflex to bash Krugman).
Posted by: Barry on July 23, 2002 11:31 AMIsn't it ironical to think that the natural outcome of the market will probably hurt the right badly in Congress? :) "It" is catching up with conservatives again... When will they learn?
Posted by: JP on July 23, 2002 01:21 PMP/E's are historically high, but interest rates are historically low as well. I'm not too concerned with the historical aspect of it, but given the level of interest rates, do the current P/E's reflect plausible or implausible risk premiums/projected earnings for stocks?
Posted by: roublen on July 23, 2002 01:48 PMIt depends on what you mean by 'natural outcome'.
IMHO, this is indeed a natural outcome of a deregulated market - a large, parasitic mass of crony capitalism. This grew until a recession blew away part of the cover, and investors realized that there was a huge problem. This led to the current panic[1].
So, in a pure market-fundamentalist sense, it would be ironic, except for the fact that the right are not free-marketeers, but rather crony capitalist lovers. They've rarely had a problem with spending tax dollars. And they love to use governmental power to help their friends and punish their enemies.
In the end, I think that the best term for what's happening to the right is 'karma'.
[1] I think that being down ~30% from a year ago, when the markets had basically recovered from 9/11, will count as a panic: http://finance.yahoo.com/q?d=c&c=&k=c1&t=1y&s=%5Edji&a=v&p=s&l=on&z=m&q=l&x=on&y=on&w=on
Posted by: Barry on July 23, 2002 01:54 PMRoublen - [under the simple, rational, model that I remember from Finance 101]:
If US government bonds are yielding roughly 5%, then the 'risk-free' return P-E should be 20:1. For stocks with higher P-E's, the assumption is that they have a lot of growth in earnings ahead of them, and/or that they are very inflation-resistant (and inflation is expected), and/or that the yield on government bonds will drop significantly below 5%.
Posted by: Barry on July 23, 2002 01:59 PM'E' is temporarily depressed due to the economic cycle. If profits return to their historic average percentage of GDP, then P/E's are currently around 18 - i.e. equity yields are above bond yields.
Posted by: Peter on July 24, 2002 12:14 AMGood point. I've just noticed that people seem to be using current earnings.
The big question is - what is the risk premium?
If treasury bonds are yielding 4.5 - 5%, what should
stocks yield? As Megan pointed out, people seemed to be treating stock risk as non-existent. Somebody said a few years ago, that the only risk was not being in the market and reaping the gains,
Assuming that that belief has been shattered, and things go back to normal (which was a 4% premium?),
how far do stocks have to go down yet?
Posted by: Barry on July 24, 2002 04:04 AMI'm just curious as to where she's getting that P/E number from. An article in Barron's last week (when the S&P 500 at 848) claims that it has a trailing 12-month P/E ratio of 17.6.
I can't reconcile Barron's numbers with hers, and they can't both be correct. Who's wrong?
Posted by: Mike Kozlowski on July 24, 2002 11:15 AMMy brother's Bloomberg screen has an S&P P/E of 28...
In a recession year, the difference between trailing P/E, current P/E, and forecast P/E can be that large...
Brad DeLong
Posted by: Brad DeLong on July 24, 2002 01:36 PMGood point, Barry. We've long come full circle, with a fiscally responsible mainstream left and a populist-big-business right. The right's ability to raise money in exchange for future favours (direct and indirect) and then spend it on populist marketing is amazing.
I wished Democrats were facing a better and more challenging right. Out of more sensible political competition one would hope to see more constructive and creative ideas spring out.
Now, I also sometimes catch myself to think that the USSR provided the US with a healthy dose of political competition as a human need fullfiling mechanism... But on this one, I have come to conclude that the resulting cost in terms of loss of effective freedom of speech (due to repression of anything that could be vaguely labelled communism) was probably too high...
Posted by: JP on July 25, 2002 12:14 AMJP - I second your wish. It would be pleasant to have to good parties. To look at the positions of each party, and to have to think, judge and weigh them before deciding whom to vote for.
Posted by: Barry on July 25, 2002 05:38 AMI would like to a have line-item-veto for candidates. "I vote for A's education plank, but against A's foriegn trade plank. Therefore, A is partially elected for education reform."
I suppose social-liberal/fiscal-conservative eventually chases it's own tail, but I do wish it had a louder voice. Problem is, voters are currently swayed by yard sign quality, not ideas.
Posted by: BEM on July 26, 2002 12:08 PM