Blog - Investing Notes

October 6, 2005 – Understating P/E?

After reviewing the behavior of S&P 500 price-earnings ratio (P/E) over the past 17 years, reader Charles in Summit NJ noted the following point of view:

Jeremy Grantham (and John Hussman) would argue that the current P/E is calculated from peak profit margins. If profit margins are normalized over the last 10 years, the P/E is much, much higher. What do you think?

The chain of logic these two experts offer is as follows:

1. Profit margins are currently high in comparison with historical levels.

2. Profit margins will mean revert to lower levels.

3. Earnings will therefore fall.

4. The P in P/E will trend downward to track falling earnings, or even faster than earnings when investors see the price-to-earnings growth ratio (PEG) rising.

We cannot fault the logic. There are highly esteemed academics who would agree that mean reversion of profitability is likely. See, for example, our recent blog entry of 9/30/05 on research by Fama and French that finds profitability reversion drives the average outperformance of low price-to-book stocks.

However, we do not see any urgency with respect to profitability reversion. We are still not seeing deterioration in forecasts from the S&P 500 earnings trackers. (We are seeing deterioration among inflation forecasts.)

We would not say Jeremy Grantham and John Hussman are "stuck on stupid," but calling for lower P/Es for years and years makes their forecasts less than useful from a market timing perspective. They will eventually be right, but we do not know when.

For related research, see Blog Synthesis: Valuation Based on Fundamentals. See also our review of the market commentary of John Hussman since September 2003.