Are the High P/Es OK?

From Paul Kroger: “I feel it may be misleading to compare P/E ratios today with historic levels. Current market P/E’s are often referred to with caution as being at ‘historically high levels.’ But, given an increasing number of people investing in stocks relative to historic levels, wouldn’t you expect this to occur? My impression is that the Conventional Wisdom has always attached a lot of risk to stocks, which kept many potential investors out of the game and handsomely rewarded those who dared play. Now we ‘Boomers’ have learned (or at least been led to believe) that the risk is short term, and that ‘in the long term stocks always provide the best return.’ All things being equal, as more investors buy into this idea (and there are a lot of us), wouldn’t you expect P/E’s to be bid up significantly from historic levels? Granted, P/E’s currently reflect an extremely optimistic outlook for earnings and are truly high by any measure. But I never hear anyone relate the increased number of equity investors to a general increase in market P/E’s.”

A.T.: I think you’ve asked a very good question.

The first point I might make is that in the second largest economy in the world, people save a lot more than we do here, relatively speaking, and they too face an aging population concerned about retirement – so their stock market must be booming, right? With all those savers shoveling in money? But the answer of course, as you know, is that the Japanese market is down 60% from its level nine years ago. (They’ve been saving, but not in Japanese stocks.)

But you’re right: So long as everyone believes stocks can only go up regardless of value … and that any dips will be shallow and short-lived … the market will keep going up, and any dips will be shallow and short-lived. P/Es can climb to the moon, at least for a while.

Still, think about what the P/E is. It’s the price you pay for a piece of the profit pie. If you buy a short-term Treasury these days, you pay $20 for $1 annual return. Totally safe. If you buy a stock at 20 times earnings, it’s the same deal – $1 of annual earnings – except you don’t actually get the dollar. You may get part of it as a dividend, but the rest will be reinvested on your behalf in hope of making the return itself – that annual dollar – grow.

In the old days, people walked around saying things like, “a bird in the hand” (by which they meant a dividend check that didn’t bounce) “is worth two in the bush” (by which they meant a share of accounting profits that are probably real but hard to spend when you get to the checkout counter at Costco).

Now of course we’re too smart to worry about dividends, which in taxable accounts must be shared with Uncle Sam; we just want stocks that go up.

Still, someone paying 28 times earnings for the average stock in the S&P 500 is saying: “Don’t give me $950 for every $10,000 I’ve saved up!” (e.g., the $950 one could earn by paying down his home equity loan) No, I’d rather have $357 (28 times $357 is $10,000). What’s more, don’t actually give me all that money, just maybe $150 or so. With the rest, do whatever you think is smartest.

Someone paying 50 times earnings for a growth stock is saying, “I’d rather earn 2% in a growing company than 9.5% by paying down my home equity loan.”

My guess is that, despite the good reasons one can marshal to pay 28 times earnings for some stocks, and even 50 times earnings for a few, the time will come when birds and hands and bushes reappear. If a recession ever surfaced, or even just the fear of one, appreciable numbers of investors might decide that 9.5% is better than sitting with stocks that pay little or nothing in dividends and could lose 10% or 30% in value (or possibly even more).

At which point, if fear reappears, as it periodically used to – be it this week or in the next century – stocks will lose 10% or 30% (or possibly even more) of their value.

And then the recession will end, greed will overtake fear, and stocks will begin climbing back.

Personally, I have no interest in accepting $200 or even $357 on each $10,000 I invest unless the circumstances are very special – as some are. I’d rather get $950 (9.5%) paying down my home equity loan. If fear ever reappeared, I’d be a more enthusiastic buyer.

So does this mean you should try to “time the market”? I suppose not – especially in a taxable account. “Everybody knows” that you can’t time the market and that missing just a few of the really great spurts in the market – which come at unpredictable times – robs you of much of the gain you might otherwise have had.

But all rules have exceptions, and when “everybody knows” something, their very knowing can make it no longer true.

Which is a very long-winded way of saying: Be careful.