Weekly Risk Report 12/14/2009
Much is made of the Price / Earnings ratio in the financial news and press. It is one of the oldest fundamental measures that is used in analyzing whether market prices are too low, too high or “just right.” It is a ratio that tells us how much the average investor is willing to pay for $1.00 worth of earnings. If people are willing to pay eighteen times a dollar’s earnings, the P/E is said to be “18.” If they’ll just pay twelve times earnings, then the P/E is “12.”
This week the Value Line P/E is 16.6 which is very close to the 10 year average value. Is that good or bad? Well, it’s “average!” It’s only when we add in another component that we begin to understand what the current P/E value means. This other component is in the form of what competes for our investment dollars – short term interest rates.
When interest rates are high, people will use short term money market funds as a safe haven for their dollars. This makes sense because high interest rates usually mean it is harder for businesses to borrow and therefore means slower corporate growth on average. When rates are low, people seek better opportunity for their dollars and will venture into the stock market. Again, when rates are low, business borrowing is easier and therefore companies can borrow to grow their businesses.
In this graphic, we first see the recent decade’s P/E ratio plotted against the S&P 500 Index. Note the blue line shows the average P/E for the period. At the bottom of the graphic, the interest rate history added as a separate element. When added together, we see a range. The Red Line delineates the most bearish 10% of the data where the Green line and below shows the most bullish 10% of the data.
As you can see, even though the P/E is “average” the combination of very low interest rates and the P/E is bullish. This explains why SignalPoint is focused on the current interest rate trend right now. If we were to see interest rates climb to even 4%, this indicator would be solidly neutral instead of bullish. Note other times when the P/E has been around where it is now and see how interest rates at that time affected our review. In 2007 it wasn’t so much the P/E that was “high”, but the combination of P/E and interest rates that signaled a high risk market.
Of the four market measures, two are neutral, and two are moderately bullish. Overall the signal is slightly bullish, but will remains so only as long as interest rates remain very low. The P/E is probably as high as it should be with more normal interest rates.
