Friday, 22 December 2017

When The P/E Ratio Peaks And Saving Plummets

The very hallmark of a financial bubble is prices dislocating from current fundamentals and any reasonable expectations of future ones. For stocks, one such fundamental is after-tax reported earnings. 

It is no secret that stock prices move in cycles. But so does earnings. This in part explains why seasoned long-term investors focus on the underlying earnings power of a company. This is also in part the reason why these investors appraise the profitability of a company over time and don't base their decisions on whatever a company reported in earnings last quarter nor what it is expected to deliver in the next. 

That is why stock prices need to be compared to earnings over a longer period of time, and not just trailing 12 months earnings or next year expected earnings. Graham recommended at least seven years. Shiller bases his CAPE (cyclically adjusted price earnings ratio) on 10 year inflation adjusted earnings. When stock market prices dislocate completely from earnings, that is, when the P/E ratio surges, it's time to pay attention no matter what the level of interest rates. 

What securities analysts (and even the high-flying "strategists") seldom talk about however (in my experience) is the profound economic importance of changes in money supply growth and how much people save, both of which play a major part in determining the ups and downs of asset prices.

When savings drop, people consume more than they earn. When this happens over a period of time, people are not only consuming wealth, but also eating away at the rainy day cushion. When the much needed credit, which makes possible living above means, tightens at the same time, economic problems become revealed in abundance. Not just for the people and families involved, but the economy as a whole. 

And here we are, 22nd December 2017, at a time when the CAPE ratio for the S&P 500 index is among the highest ever recorded while the personal saving rate in the U.S. is plummeting. Comparing the two, there a good reasons to be pessimistic about future stock market returns. 



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