David Leonhardt looks
at p/e ratios today – but not the p/e ratios we know and love, where
the denominator is this year’s (or last year’s, or next year’s) earnings. Rather,
he tries to even out the business cycle by looking at earnings over the past
ten years. And by that measure, p/e ratios look high, by historical
standards.
For years, John Y. Campbell and Robert J. Shiller have been calculating long-term
P/E ratios. When they were invited to a make a presentation to Alan Greenspan
in 1996, they used the statistic to argue that stocks were badly overvalued.
A few days later, Mr. Greenspan touched off a brief worldwide sell-off by
wondering aloud whether “irrational exuberance” was infecting
the markets…
Today, the Graham-Dodd approach produces a very different picture from the
one that Wall Street has been offering. Based on average profits over the
last 10 years, the P/E ratio has been hovering around 27 recently. That’s
higher than it has been at any other point over the last 130 years, save the
great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was
so big, in other words, that the market may still not have fully worked it
off.
As we all remember, the "worldwide sell-off" in the wake of Greenspan’s
"irrational exuberance" comments was followed by the biggest stock-market
bubble of all time. But have a look at Leonhardt’s chart – it turns out
that even after the bubble burst, long-term p/e ratios still remained
at or above the "irrationally exuberant" levels of 1996. Greenspan’s
ideas of what was overpriced seem, in retrospect, to have been something of
a floor in terms of how far the market could drop.
And I simply don’t understand what Leonhardt is talking about when he refers
to the market "working off" its bubble. Bubbles aren’t "worked
off". They burst. Dramatically. And the market, according to all economic
received wisdom, tends to overshoot, not undershoot, in such a scenario –
in other words, far from falling too little, it tends to fall too much.
Maybe there’s some kind of meta-bubble explanation. Stocks in general got bubbly
in the early 90s, and then a tech bubble grew out of the more mainstream bubble.
The tech bubble burst, but the mainstream bubble didn’t. But I don’t buy it
myself.
Or maybe, as Leonhardt himself proposes, there really has been a secular change:
Over the last few years, corporate profits have soared. Economies around
the world have been growing, new technologies have made companies more efficient
and for a variety of reasons — globalization and automation chief among
them — workers have not been able to demand big pay increases. In just
three years, from 2003 to 2006, inflation-adjusted corporate profits jumped
more than 30 percent, according to the Commerce Department. This profit boom
has allowed standard, one-year P/E ratios to remain fairly low.
Going forward, one possibility is that the boom will continue. In this case,
the Graham-Dodd P/E ratio doesn’t really matter. It is capturing a reality
that no longer exists, and stocks could do well over the next few years.
Dean Baker doesn’t
buy it.
Leonhardt felt the need to say that maybe stocks aren’t over-valued if profits
keep growing rapidly (sounds like Alan Greenspan in the 90s). Well don’t hold
your breath on that one. Profits peaked in the 3rd quarter of 2006 and were
down sharply in the 4th quarter of 2006 and the first quarter of 2007. It’s
always possible that they will bounce back, just like it’s possible that President
Bush will sign the Kyoto agreement, but I don’t know anyone who will bet on
either event.
I’m more sanguine than Baker on this one. Leonhardt isn’t talking about quarter-to-quarter
fluctuations in corporate profitability, and he’s certainly not saying
that the business cycle has been repealed. He’s just saying that maybe there’s
been a permanent move whereby capital gets a larger share of the total economic
pie, relative to labor, than it has done historically. If that were the case,
then it would indeed be silly to compare stock prices today to those companies’
earnings ten years ago, before that change really kicked in.
Remember that Leonhardt is looking at the price of stocks today, divided by
average earnings over the past ten years. Given that recent years have seen
much higher profits than those recorded a decade ago, the denominator
of that ratio is going to increase steadily even if quarterly earnings do decline
over the next year or two.