In response my request, Lance Roberts of StreetTalkLive was generous enough to provide me with his copy of the SPX PE ratio data file (monthly) to carry out my own analysis on it. I enjoy the depth, balance and consideration Lance brings into his articles and I consider him a member of select few on the planet to provide consistently lucid and relevant analysis regardless of the prevailing atmosphere. Moreover, the material posted by all the folks on the Advisor Perspectives blog hosted by Doug Short provides plenty of brain food for those interested.
On reading Lance’s article above, I wondered what things would look like if I could do my own proprietary analysis on the data. Below is the output of various valid methods of determining the non-linearity, linearity and periodicity of the underlying trends of the PE ratio.
In order of decreasing optimism, the results are –
Will leave it up to the reader to decide the relevance of all or none of the above.
The P/E ratio of 2000 exudes characteristics most like the equity bubble of 1928-1930 (roaring 20’s) – except with larger magnitude and increased P/E ratio volatility*. The period of 1983-2010 (27yrs) either side of 2000 and the reaction since is also most similar to the period 1920 to 1940 (20 years).
* Not to be confused with index volatility, which is a separate consideration
There is an obvious upward sloping linear regression average underlying the overall trend. This is concerning as fundamentally P/E ratios should historically have a flat regression since it is a reflection of the level of confidence in forward earnings stability. The author believes this should be cyclic but consistent returning to historical norms. That this is rising can suggest an acceptance of capital gains over a general deterioration in the underlying earnings capacity. Hence there remains an underlying tendency to increase P/E ratios for some reason – however this might also be a sign of how far P/E ratios are yet to reset to a horizontal norm. Caution is certainly warranted.
Cyclically there is a clear and dominant supercycle of approximate pk-pk 33years 4months (averaged) with magnitude +/-8. Observable peaks 1900.0 (exact), 1933.04 (close, v.choppy), 1966.0 (sl.early) and 2000.0 (exact). The next projected minima for this cycle* is Oct2015. Locally, there are higher frequency major cycles of 8-9 and 10-11 years (pk-pk) with a smaller 5-6year (pk-pk) overlayed. The cumulative effect results in highly volatile periods as observed currently, as in 1930-1940. The cycle period 8.75yrs (pk-pk) is presently quite dominant creating observed volatility in combination with the 5-6yr (pk-pk) cycle.
* Super cycles can have minimums that do not coincide with observed lows, as it is a combination of reinforced coincidence with smaller, higher frequency cycles – the timing of the actual low can be subject to other periodicities (refer to the subjects of constructive and destructive interference).
It is not beyond reason that a P/E ratio low of 12.x (and possibly as low as 10.x) be experienced in the next 5-7 years, most certainly before 2020 with cyclic continuity suggesting quite strongly this will occur prior to 2017 under sustained volatility in the P/E ratio. The combination of Super,Major and Minor cycle dynamics will not place this low exactly, and lows either side of this period (+/-2 years) would be entirely normal and should be expected. I suspect this to be predominantly due to the 105pd (8.75yr pk-pk) major cycle of +/-2 magnitude.
The period 1981 to 2000 was unprecedented in magnitude resulting in a massive outlier peak P/E ratio of 44.2 which is historically unsustainable and considered an irrational precedent. However cyclic coincidence via constructive reinforcement of periodicity can certainly help explain the observed peak.
It is acknowledged that the 2 primary elements of the P/E ratio can and do move independently with observable periodicity. I personally do not consider the PE ratio to have any physical definition attached to a fixed and tangible reality, as evidenced by the spike in periods of 1928 and 2000. A PE ratio on it’s own is for story telling, and the story above is compelling enough.
The likely catalyst for any further downturn as depicted above will be a run on calls on derivatives contracts, and the requisite scramble for capital. Equities are the closest thing attached to reality for Tier 1 bank capital globally. The problem is the global equity market capitalisation (reflecting tangible and intangible equity valuation) is roughly $50Trillion, being collateral for a $700Trillion derivatives market. If banks are reporting greater than 80% Tier 1 capital listed as common stock, then for these banks the derivative market is much like a nuclear device with an exposed core and a faulty interface.
This will not be a black swan event. The hope is the US has recapitalised its banking system with some $2.4Trillion injected via the recent and massive balance sheet expansion of the Federal Reserve juiced up on ZIRP. To say they are standing ready for any implosion is an understatement. The same cannot be said for the circus on display in Europe.