The WSJ Morning MoneyBeat blog post for Tuesday, March 22, was entitled, “Energy Stocks Are the Most Expensive in S&P 500.”
Are they really?
As I read the WSJ’s post, I decided I really have to use this as an opportunity to help dispel some widely – nay, almost universally held – notions about using P/E ratios to predict stock price movements.
How Not To Use P/E
Almost all investors, in my experience, routinely fall into the trap of misusing the P/E. In fact, I admit I fell into the same bad habit for many years myself. Until a couple of years ago (more on that later).
Don’t get me wrong. It’s not that the ratio can’t be useful. On the contrary, when properly interpreted, P/E can be an indication of sentiment, which is always important for an investor to understand. When P/Es are low (remembering to mentally adjust absolute P/E figures to account for differences in interest rates, inflation, and other market conditions in order to accurately assess whether P/Es are truly “low” or not), sentiment is probably somewhat sour, generally speaking. High P/Es (all things considered) generally mean investors feel willing to “pay up” for earnings, growth, dividends, and/or other perceived benefits of owning stocks. And again, having a feel for what the market’s sentiment is can be helpful (often in a contrarian sort of way).
Beyond the ratio’s use as a rough sentiment gauge, however, I’ve learned several things in the last couple years about using (or misusing) P/E ratios (for individual stocks and for the broad markets), which I’ll summarize as follows:
• In the short-term (1-3 years or shorter), P/E ratios have very little (if any) correlation to price movements.
• In the short-term, P/E ratios almost absolutely do NOT cause, explain, or predict price movements. (Note: causation is different than coincidental correlation).
• In the long-term, P/E ratios STILL have very little correlation to price movements.
• In the long-term, P/E ratios STILL cause or explain only a small fraction of price movements. In other words, other factors are much more responsible for price movement than is the P/E.
• Bottom line, you really can’t use P/E to predict price movements, either in the short term or the long term! Again, P/E’s only usefulness is as a rough gauge of sentiment.
Now, most people know – cognitively, at least – P/Es don’t help predict stock movements in the short term. I always knew that as well. But until a couple of years ago, I still often found myself getting sucked into the trap of overly relying on P/Es predict short-term price movements anyway! I don’t do that anymore. But (no thanks to the media, I think), I see many investors still falling into the same old trap!
My Catharsis – How I Learned (The Hard Way) To Properly Use P/E Ratios
After the Crash of 2008, I thought I was being really smart to recognize that each of history’s major, multi-year bull markets had started with a P/E below 9. So, since the 2008-’09 market P/E never descended to those extreme levels before proceeding to rise higher, I made a mistake in my own investments and in my investment advisory practice. I made a big, overconfident bet that 2009’s recovery would not be a lasting one, nor would it lead to a bull market. I truly felt, in my infinite wisdom (pshaw!) that I was being smart enough to NOT use P/E to predict short-term prices because I knew that would be ineffective. Rather, I simply felt (quite smugly) I’d eventually be proven correct in the long-term. I believed any bull run would be ultimately wiped out by a crash bigger than 2008, based primarily on my confidence in not only the P/E, but in Nobel laureate Robert Shiller’s “cyclically adjusted price-to-earnings” (CAPE) ratio.
Of course, being too conservative throughout the US market’s bull run from 2009-2014 was quite an uncomfortable position to be in! Especially in 2013!
Then I read Ken Fisher’s New York Times best-selling book, The Only Three Questions That Still Count: Investing By Knowing What Others Don’t. (As an aside, I highly recommend the read. A handful of books can almost be considered an investing Bible. This, to me, is one of those).
In the book, Fisher specifically addresses – head-on – the very fallacies to which I had fallen prey; namely, Shiller’s CAPE, and even more broadly, the pitfall of using P/E ratios to predict long-term stock prices.
In the interest of brevity, I’ll refer you to Fisher’s book for the statistical and historical proofs. He does a masterful job of tearing apart the myths. So I’ll simply move on to the WSJ blog I referenced earlier, as a way to illustrate the current debate over energy-sector P/Es. In the end, I welcome your comments, feedback, and experiences as well.
Will Today’s Energy Sector P/Es Be Predictive Of Future Returns?
In this last section of today’s article, I’ll quote excerpts from the WSJ blog post, then insert my comments (labeled AF, as in my initials). I’m taking the WSJ’s excerpts in the order they appear in the WSJ’s article. Here goes:
WSJ: “Energy companies have the highest trailing price-to-earnings ratio of any sector in the S&P 500.”
AF: Okay, so we’re talking about “trailing” P/Es, meaning we’re looking backward over the last 12 months. Not only are P/Es not predictive, but “trailing” P/Es are even worse. Why? Because (quite simply) the stock market is forward-looking, not backward-looking. What do earnings from April 2015 have to do with returns from April 2016 to April 2017? Very little, if anything. Per Fisher, markets tend to look about 18-24 months ahead, or perhaps sometimes as high as 36 months. Markets never look backward, though.
Note, this same logic extends (even more so) to Shiller’s much-hyped CAPE ratio, which uses earnings over an arbitrary 10-year trailing basis. Which leads to the even more preposterous question, what do earnings from as far back as April 2006 have to do with returns from April 2016 to April 2017? Answer: absolutely nothing! Yet Shiller’s ratio actually uses data from 10 years ago in its denominator, as an arbitrary “smoothing” method. Very bizarre, if you think about it!
Note further that Fisher points out even Shiller’s own original paper admits only about 40% of the variability in long-term stock prices is statistically explained by CAPE. Meaning 60% or so of long-term prices are determined by factors other than CAPE. I wish I had known that before making my overconfident decision in 2009 to bet on a big double-dip. Price matters, but so do many other important factors – especially when prices are within a reasonable range. At the extremes (i.e., Black Swans, spikes, bubbles, etc.), I reckon, prices do matter more than usual. The trouble is, though, it’s very tough to know when the “extremes” are at their most extreme. Case-in-point: energy stocks today. Have we hit bottom, or is a huge double-dip coming? (I don’t know).
And finally note (last one): For all the limitations of backward-looking “trailing” earnings data in P/E’s denominator, forward P/Es are problematic in their own right, because forward earnings are (by definition) not yet known. Still, I’d prefer to use a good, thoughtfully calculated forward-looking P/E as a sentiment gauge, as long as the ratio is taken with a large grain (or two) of salt.
WSJ: “A P/E ratio can increase as share prices rise or earnings decline. For energy, it’s both.”
AF: So, the WSJ is saying energy stock prices have been rising? Sure, a tad bit recently, I suppose. In the next paragraph, the WSJ quantifies all this, as follows: “The S&P’s energy sector has advanced 5% so far this year as crude-oil prices have rallied.”
I’d hardly call that “rising share prices,” after the 40% decline in the Energy Select Sector SPDR ETF (XLE) from June 20, 2014, through December 31, 2015. XLE was once $100 per share before beginning its slide all the way to $50 on January 20th. It’s now $63, which is quite a 2-month bounce! But not an explanation for why energy’s P/E is higher than the market P/E.
As for whether energy companies’ earnings have been declining, well of course they have. As the WSJ says, “The sector’s fourth-quarter earnings tumbled nearly 73%, according to FactSet.” Yes, and history shows that trailing P/Es can be even less predictive in the midst of massive earnings crashes like this one, when you see some truly bizarre trailing P/E figures (more on this in a moment).
WSJ: “The stretched valuations reflect investors’ expectations that the worst is over for the energy sector, but also makes the stocks vulnerable to a sharp pullback if commodity prices fall again, or investors rush to sell expensive holdings if the market cools.”
AF: The part about “stretched valuations” reflecting investors’ expectations probably has some truth to it. Again, P/Es can reflect sentiment. So what could high energy P/Es be telling us in this case (if in fact appropriately measured P/Es are truly high)? Well, if investors believe the worst is over, perhaps investors aren't pessimistic enough for a true bull to begin. Remember, “Bull markets are born on pessimism,” John Templeton said. High P/Es could imply investors aren’t yet pessimistic (or capitulatory) enough… and on this point, I would tend to believe the WSJ may be correct. Anecdotally, to me, it still seems to me too many investors are “in there” trying to “buy the dips” in energy stocks.
But...
Do high P/Es necessarily “make stocks vulnerable to a sharp pullback”? No! Remember my catharsis?! This is the whole point. Since when can P/Es explain or cause short-term price movement? Since never! Stocks and markets with high P/Es routinely stay high (and continue higher) for years! And vice versa. P/Es are not a predictor, particularly not in the short-term. They’re just a very rough sentiment gauge.
WSJ: “In the meantime, (the higher P/E) shows investors’ renewed appetite for risk, a trend that has pulled major indexes back from multiyear lows hit last month.”
AF: Okay, now you try. Could the WSJ be correct that higher P/Es show investors’ renewed appetite for risk? I’d say yes, to the extent P/Es have gone higher recently, those higher P/Es might reflect increased risk appetites, as “risk appetite” is a sentiment. That’s how you use P/E.
However...
Did the “trend” for renewed risk appetite indeed pull major indexes back from multiyear lows, as the WSJ asserts? Well, I don’t see how, since the WSJ is saying energy P/Es were low last month. If P/Es were low, then there was no “trend” of renewed risk appetite when the rally began. Thus, the “risk appetite” sentiment wasn’t reflected in P/Es until after the rally. P/Es are not a predictor. At best, they’re a snapshot of concurrent sentiment.
WSJ: “Energy companies in the S&P 500 trade at 38.8 times the past 12 months of earnings as of Friday, according to FactSet. That’s sharply higher than the sector’s average price-to-earnings ratio of 13.1 over the last 10 years. On Dec. 31, the sector traded at 21.8 times the past year of earnings.”
AF: Holy smokes. These trailing P/Es are all over the map! As I mentioned earlier, the insanely volatile “earnings” data in the denominator render trailing P/Es basically useless right now, in the energy sector particularly.
Another point: How many investors would have considered the energy sector’s 21.8 P/E on 12/31/2015 to be “cheap”? Not many, since the market’s trailing P/E has recently been stuck around 18. Yet the WSJ opines that investors “have been pouring money into what had been the market’s most beaten-down sectors,” including energy. Using their logic, how was energy one of the most beaten-down sectors if it had a higher-than-market P/E?
Now, of course, I understand the WSJ is really saying the energy sector was the most beaten down in terms of absolute price declines, not in P/E. But this still contradicts the assertion energy stocks' February P/Es could have in any way predicted price movement. If anyone thought P/Es to be predictive in the short term, last month just disproved the notion! Else, why would a sector with a 21 P/E outperform the market, with it's 18 P/E?
Conclusion
I don’t mean to bash the WSJ. I read the Morning MoneyBeat blog almost every day. I just hope my insights here can help illuminate the error of using P/Es to predict stock performance. Hopefully, you’ll be able to kick the habit, as I have.
Best,
Adam Feik
INO.com Contributor - Energies
Disclosure: At the time of post publication, this contributor owned Enterprise Product Partners (EDP), but did not own any other stock mentioned. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
