Tools, jewels and P/E ra­tios

Financial Mirror (Cyprus) - - FRONT PAGE -

There are two ba­sic rea­sons why an as­set has value and this un­der­stand­ing should be foun­da­tional knowl­edge for any­one run­ning a port­fo­lio. They can be prized for their ef­fi­ciency (a tool) or de­sired be­cause of their scarcity (a jewel). In­vestors’ pref­er­ences for jewels ver­sus tools will shift through time, but what does not change is the fact that scarcity can­not lead to eco­nomic growth; only the ap­pli­ca­tion of ef­fi­cient as­sets al­lows so­ci­ety to pro­gres­sively ex­pand its output, and along the way en­rich those who have in­vested in the means of pro­duc­tion.

By way of ex­am­ple, I shall in this piece use sil­ver as a proxy for scarcity (the gold price was con­trolled un­til 1971) and the S&P 500 as an ef­fi­ciency mea­sure of the US eco­nomic sys­tem. It fol­lows that a ra­tio be­tween these two vari­ables will il­lus­trate the re­la­tion­ship be­tween ef­fi­ciency and scarcity. In pe­ri­ods when the re­la­tion­ship is ris­ing it fol­lows that US eco­nomic poli­cies are con­ducive to growth. Con­versely, in pe­ri­ods when the ra­tio is in de­cline, the re­verse sit­u­a­tion must be true.

In ad­di­tion, dur­ing phases when in­vestors per­ceive the outlook for growth to be fa­vor­able for years to come price/earn­ings ra­tios tend to rise. This can be thought of as mar­kets ex­pand­ing the du­ra­tion of the cash flows that they are will­ing to dis­count into the fu­ture. Hence in good the­ory there should be a clear re­la­tion­ship be­tween the S&P 500/sil­ver price ra­tio and the long term evo­lu­tion of P/E ra­tios. And, in­deed, this is the case as shown in the chart over­leaf where it can be seen that the Shiller cycli­cally ad­justed P/E ra­tio (a smoothed form of the clas­si­cal P/E) and my tool/jewel ra­tio tracks to such an ex­tent that since 1920 the two vari­ables have a cor­re­la­tion of about 0.9.

My next task is to test whether eco­nomic poli­cies did, in fact, prove to be con­ducive to growth, or not as the case may be. For this pur­pose, I use the real in­ter­est rate of­fered by three month trea­sury bills—neg­a­tive real rates re­flect “bad” pol­icy set­tings un­con­ducive to growth, while pos­i­tive real rates de­note “good” set­tings.

And re­mark­ably it turns out that good eco­nomic poli­cies are usu­ally as­so­ci­ated with higher P/Es, and bad eco­nomic poli­cies with lower P/Es. Put another way, in each phase when overtly Key­ne­sian poli­cies have been adopted (read long stretches of neg­a­tive real rates) sil­ver has, af­ter a while, be­gun to out­per­form the S&P 500, while in these phases, P/E ra­tios have tended to ei­ther fall or sim­ply go nowhere.

As a re­sult, my de­ci­sion rule is that when sil­ver out­per­forms the S&P for 18 months straight, I be­come fairly cer­tain that P/E ra­tios will en­ter a pe­riod of struc­tural de­cline. It should be noted that in the last 18 months, sil­ver has out­per­formed the S&P 500 by 13%, so it seems likely that a long term mar­ket de­r­at­ing has prob­a­bly started. Since the US equity mar­ket is start­ing from a hefty 25x P/E, there is po­ten­tially a long way to fall.

With cor­po­rate Amer­ica mid-way through an un­re­mark­able earn­ings sea­son it is worth not­ing that for the mar­ket to off­set a de­cline in the P/E ra­tio, earn­ings would need to rise markedly. Yet, over the last two years the 12 month trail­ing EPS of the S&P 500 has de­clined by about 9% a year.

US equity prices were able to stay sta­ble over the last two years not be­cause of higher earn­ings, but due to a P/E ex­pan­sion that prob­a­bly re­sulted from the grind­ing de­cline in long rates. Yet, it should be noted that over the last 18 months this P/E ex­pan­sion did not pre­vent the stock mar­ket from un­der­per­form­ing sil­ver.

Given the con­flu­ence of bad eco­nomic poli­cies and the bad sig­nal com­ing from the ef­fi­ciency/scarcity mea­sure the con­clu­sion must be that US eq­ui­ties look pre­car­i­ously bal­anced.

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