Seventy-nine years ago the crash of Black Monday and Black Tuesday on October 28–29, 1929, cut stock prices by 23 percent. Economists now generally consider the misguided monetary and fiscal policies that followed (tightening on both counts) the cause of the Great Depression, not the stock market crash (which eventually cut stock prices 89 percent from their peak). Hopefully, we are not embarking at present on a controlled experiment to see whether they have been right. There could be a significant market recovery by end-2009 if mainstream earnings projections are achieved and price-earnings ratios return to more normal levels.
Monetary and fiscal policies are on track to stimulate the economy, but it is unclear how much stock prices will revive, or whether they will fall further. What is clear is that the fate of the stock market will affect the fate of the economy. At the end of 2007, total equity-market valuation stood at $21.5 trillion. Households held $5.5 trillion directly in stocks and $5.1 trillion in mutual funds.1 So the 40 percent decline in the market since then (S&P500) reduces household wealth by about $4 trillion. If this loss of wealth were perceived to be permanent, the result would be a cutback in annual consumption of about 3 to 5 percent—$120 billion to $200 billion, or about 1 to 1.5 percent of GDP. The drag on the economy would be even greater if stocks were to plunge further, which could certainly happen.
For a while the stock market seemed to be a harsh monitor of how well the financial crisis was being managed. It was not until the 9 percent plunge of the market on Monday, September 29 after congress first rejected the Bush Administration’s Troubled Asset Relief Program (TARP) that legislators got the message that their constituents had shifted from anger about bailing out Wall Street to fear about an imploding financial system. More recently, following improved confidence in the banks in light of recapitalization using $250 billion of the TARP money, the market’s focus seems to have moved on to worries about a severe recession and its effect on earnings. The major indexes have been at lows not seen since early 2003 following the bursting of the dot-com stock bubble.
Famed investor Warren Buffett has issued a clear buy signal, calling stocks a historical bargain. Is he right?
One traditional measure is the price/earnings ratio. This ratio has a meaningful basis in theory, which says that an asset is worth the discounted present value of the future earnings that it can be expected to generate. If earnings had no growth at all, the present value of a future stream of constant annual earnings of E would be: P = E / (i + r), where i is the risk-free interest rate and r is the additional discount factor for risk. If instead earnings grow steadily at rate g, then in arriving at the capitalized (or present-discounted) value, the discount rate should be net of this rate of earnings growth. So the present value would be: P = E / (i + r – g). For stocks, the price/earnings ratio should then be: P/E = 1 / (i + r – g).
Over the past five decades, earnings on the S&P 500 have grown at about 7 percent per year. The 10-year Treasury bond rate has also averaged 7 percent (nominal rates, not adjusted for inflation, in both cases). The average price/earnings ratio has been 17. This means that the implied average equity risk discount factor was 5.9 percent. That is: 17 = 1 / (.07 + .059 – .07). The ratio stood at about 18 in the 1960s, fell to about 12 in the 1970s and 1980s in the face of high inflation and the recessions of 1974, 1980, and 1982, but surged to about 24 in the 1990s and has averaged about 19 in 2001–07.2 The levels of the 1960s and the present decade seem more indicative of long-term norms than either the depressed levels of the 1970s and 1980s or the exuberant levels of the 1990s.
Conditions today have surely increased the risk discount factor at least temporarily. However, earnings have also been temporarily depressed and prospective earnings over the next year or so are also likely to be lower than their long-term trend because of the recession. So the price/earnings ratio, using recent earnings, could either be expected to be below or above the historical average, depending on whether the temporary depression of earnings dominates (boosting the price/earnings ratio) or the temporary surge in risk dominates (reducing the ratio). More broadly, a swing from excessive enthusiasm to excessive pessimism would tend to cause the price/earnings ratio to fall from its usual levels.
To complicate matters, there are two concepts of earnings typically used to examine price/earnings ratios: “operating” earnings, which do not deduct write-offs, and “as-reported” earnings, which do. At the moment, the legacy of toxic assets has caused an unusually wide gap between the two concepts. There is yet another complication in the time frame of earnings used: typically either “trailing four-quarter” (the most recent four quarters of earnings), or “forward” earnings, those predicted for the coming four quarters.
Figure 1 shows trailing four-quarter earnings per share for the S&P500 index (left axis) and the level of that stock index (right axis) over the past two decades. Both earnings concepts are shown.3 It is clear that although through most of the 1990s the two earnings measures were close together, as-reported earnings fell far below operating earnings in 2002–03, and have recently done so again. For the four quarters ending September 2008, operating earnings per share were about $68, whereas as-reported earnings were only $50. The figure’s scale for the left and right axes indicate that overall the price/earnings ratio has been about 18 to 1. Prices were far above the normal relationship to earnings in the stock-market bubble of 1997–2000. By 2003, they were back down to about the usual ratio to operating earnings (the blue line rejoined the red line), but still well above the usual relationship to as-reported earnings (literally, the bottom line).
At the end of 2007, the S&P 500 index was back to about its normal relationship to the two earnings measure. By October 29, 2008, however, the index had plunged far below the usual relationship to trailing four-quarter operating earnings. But because of massive write-offs, the price index was at about its usual relationship to as-reported earnings. So whether the market is cheap depends importantly on whether one thinks that as-reported earnings, at $50 per share, are considerably depressed from the levels they can be expected to reach in the next couple of years and after. If past history is a guide, the gap between operating and as-reported earnings should narrow once again, so there are grounds for thinking that recent as-reported earnings are atypically low.
Earnings averages over several years are sometimes used as a more reliable guide than just the most recent year’s earnings. Figure 2 reports price/earnings ratios for the S&P 500 under two earnings concepts (operating and as-reported) as well as two time frames for earnings (trailing four-quarter and trailing twelve-quarter). The final observation is again for October 29, 2008. The figure suggests that under all four definitions, the price/earnings ratio is toward the lower part of the range observed over the past two decades. The figure also reveals that on three of the four measures, the highest price/earnings ratios occurred in the dot-com bubble, but on one measure—reported one-year trailing earnings—the collapse in earnings caused the price/earnings ratio to peak in the recession that followed it, in mid-2002.
Figure 1 S&P500 Price and Earnings
The broad thrust of the evidence in figures 1 and 2 thus seems to be that Warren Buffett is probably right. By the price/earnings measures, stocks are cheap. The 20-year average price/earnings ratios for trailing four quarters are 19.2 for operating earnings and 22.6 for as-reported earnings. The averages for trailing twelve quarters are 21.0 (operating) and 24.1 (as-reported). By contrast, as of October 29, 2008, the one-year measures were at 13.9 (operating) and 18.7 (as-reported), and the three-year measures were at 11.6 (operating) and 13.6 (as-reported). Averaging over all four measures, then, stocks are now priced at only about two-thirds the levels that would have been characteristic of the past two decades. Even taking account of the fact that stocks were clearly overpriced in an important sub-period, the dot-com bubble of 1997–2000, does not much change this conclusion.4
Figure 2 Price to Earnings Ratio
Standard and Poor’s compiles a survey of earnings projections by both bottom-up (company analyst) and top-down (macroeconomic) forecasters. For the full year 2009, these projections per share of the S&P 500 are as follows: operating earnings, $97.32 (bottom-up) or $62.40 (top-down); as-reported earnings, $48.52 (top-down). If these estimates are applied to the respective price/earnings multiples for one-year and three-year earnings averages, using the twenty-year averages excluding the dot-com bubble period, the resulting estimates for the S&P 500 index by year-end 2009 are as shown in figure 3. Against the closing level of 930 on October 29, these projections range from an increase of 12 percent (reported, one-year, top-down) to 88 percent (operating, one-year, bottom up). Again the suggestion is that stocks are indeed cheap, albeit not by much if the top-down, one-year basis is applied.
Figure 3 Implied end-2009 S&P 500 index level based on earnings projections
|Note: OP = operating; RP = as-reported; 1 = one-year; 3 = three-years average; B = bottom-up;
T = top-down
Overall, fear seems to be dominating the stock market at present: the depression of price/earnings ratios from a rise in the risk discount seems to be overwhelming the prospect of above-average future-earnings growth from a temporarily depressed level. When and if this fear eases and investors shift their attention from concern about near-term financial collapse and recession to long-term preservation and growth of their capital, and especially if the mainstream earnings projections for 2009 prove valid, the stock market could begin to stage a recovery. That could only be healthful for the real economy.
1. Federal Reserve, Flow of Funds Accounts of the United States, June, 2008.
4. If the data for 1997 through mid-2000 are excluded, the average price/earnings ratios are 18.0 (operating) and 21.5 (as-reported), one-year basis; and 19.5 (operating) and 22.8 (as-reported), three-year basis.