STOCKS ARE CHEAP, BUT THIS METRIC DOESN’T WORK?

August 30, 2010

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STOCKS ARE CHEAP, BUT THIS METRIC DOESN’T WORK?

WHEN PEOPLE THINK OF IMPORTANT JOBS THAT CAN NOT BE LEFT OUT OF OUR LIVES THEY DO NOT NORMALLY THINK OF WASTE COLLECTORS. BUT DURING A HAULERS STRIKE GARBAGE PILES UP AND BEGINS TO SMELL. THERE IS NOWHERE TO PLACE IT ALL AND PESTS RUN RAMPANT AS THEIR AVAILABLE FOOD BECOMES ABUNDANT. DUMPSTERS OVERFILLED TRASH WASTE HAULER STRIKE

I’ll be frank – I have a special place in my heart for the PE ratio and it is the same place where all the things I hate are stored. This simple to understand metric has, in my opinion, resulted in more misguided Wall Street thinking than just about any metric in existence. A quick glance at the breakdown of the PE ratio shows serious flaws at work here. It is basically a moving price target (which is never correct unless you still believe in EMH) divided by the earnings estimates that are created by analysts who have literally no idea where future earnings will be. In other words, you might as well pick random numbers out of a hat and divide them and then go buy or sell stocks. Naturally, proponents of the PE ratio will say that you shouldn’t use forward PE’s, but to those people I have to respond: do you always drive through your rear view mirror? The numerator (or market price in the PE equation) could care less about past earnings so it’s less than helpful in telling us where future prices might go.

What disgusts me even more about this metric is its incessant use in selling buy and hold strategies. You can’t read a book on value investing or buy and hold without running into the PE ratio. “The market is cheap – stocks for the long-run!” You’ve probably seen this slogan on every mutual fund pamphlet you’ve ever read. Your stock broker no doubt thinks the market is “cheap” right now. The PE ratio has become the sales pitch of an entire generation of sales people who are just herding small investors into fee based products. “Did you know Warren Buffet is a value investor?” “Just buy cheap stocks and hang on. Your status on the list of the world’s richest is in the making!” Or so goes the old sales pitch.

So, I wasn’t surprised to open Yahoo Finance this morning to see the following headline arguing that stocks are cheap according to the PE ratio. But just two articles down is an article from the WSJ arguing that the PE ratio doesn’t work in this environment. You can’t make this stuff up. According to the article:

“Not only is the P/E ratio dropping, it also is in danger of losing some of its prominence as a market gauge.”

pe STOCKS ARE CHEAP, BUT THIS METRIC DOESNT WORK?

Losing its prominence? The only reason this metric ever gained prominence was in large part due to the WallStreet sales machine that has spent the last 25 years selling the idea of buy and hold to a generation of investors who thought they were on their way to becoming the next Warren Buffett. Unfortunately, investors like to latch onto what’s simple. Few things are easier to understand in the complex world of investing than the PE ratio.

I generally adhere to the slogan: “you know less than you think you know”. And I consider myself a pretty savvy investor. I understand the complexities of monetary theory, I’ve traded just about every instrument under the sun, I have seen the inner workings of Wall Street’s slimiest firms, I’ve been lucky enough to outperform the markets for years on end and yet I still am consistently humbled by the markets. I certainly know less than I think I know. In the case of your average Main Street investor you know less than less than you think you know. This idea that anyone can become the next great investor is like me walking into a Harvard Law class and proclaiming that I can talk, therefore, I am the second coming of Johnny Cochran. It’s just not that simple. Yet, the sales pitch continues and the small investor continues to eat up the dream…

close-up of a shark swimming over a coral reef

The PE ratio is certainly simple. In fact, it’s too simple. Buying stocks or convincing yourself that the market is “cheap” based on the results of two incorrect moving targets is not only a recipe for disaster, but it’s sheer lunacy in my opinion. The contradicting headlines above show just what a confused and bewildering place Wall Street is to begin with. I can only imagine what your average Main Street investor is beginning to think of this place we call “Wall Street”.

Trying to dumb down a system as complex as the market only misleads small investors into believing that they can swim with the sharks without being eaten. The PE ratio has only helped herd more and more small investors into equities with the belief that they too can become the next Warren Buffett. But hey, where will Wall Street be if the little guy ever figures out that Wall Street might not be the right place for their money? Wall Street might actually shrink. This unproductive facet of the US economy might actually sink back to the meager corner that it once maintained. And while that might be a bad thing for the big banks it would likely be great for the long-term productivity of the US economy and the wealth of Main Street citizens – all of whom are invested in the United States though not necessarily in the form of Wall Street products.