Wednesday, January 7, 2009 2 comments ++[ CLICK TO COMMENT ]++

Graham-Dodd 10-year P/E still not low enough

How attractive is the market? The Graham-Dodd 10 year P/E ratio, using data compiled by Robert Shiller, still indicates that the market is nowhere near being a steal. It's attractive but by no means cheap.

(note: the following chart goes up to the end of 2008 but we don't have earnings for 4Q2008 so the data point is an estimate. Having said that, given that this is a 10 year average, that point will only have a marginal impact. Furthermore, earnings likely dropped, particularly for cyclicals such as autos and commodity businesses so the p/e ratio likely didn't improve.)



(You can get the source data from Robert Shiller's site (direct link to spreadsheet here.))

One of my first posts back in early 2007 on this blog was the 10 year P/E chart courtesy The New York Times. The good news is that the 10 year P/E ratio, which stood around 20 at that time, has completely collapsed. Now it's around 15.

The bad news--yes, there is always a bad to the good--is that the ratio is still nowhere near the lows set after massive bull markets in the past. The P/E ratio was around 10 (or lower) in the early 1920's, early 1930's, most of the 1940's, and early 1980's. Since this is a 10 year P/E, getting to 10 from 15 is painful. It means a long period of flat prices and increasing earnings, or continuously declining prices with tepid earnings.

There are only two arguments that bulls can make, in my eyes.

Firstly, they can argue that Warren Buffett called a bottom so we are hitting prices that are worth buying. Warren Buffett is very poor at macro calls (otherwise he never would have invested in USG) but he has a very good sense of overall valuations. So I think the argument that Buffett called it so everyone should blindly go long has some merit. The only caveat is that it could take quite a while for the market to reward you. Buffett called the bottom in 1974--Dow never hit that level ever since--but investors suffered all throughout the 70's and early 80's.

The second argument bulls can make is that interest rates are low. I personally do not invest based on interest rates in a particular market. This is primarily because I'm a global investor. The fact that interest rates in Japan are around 1% doesn't mean that I'm willing to buy stocks with P/Es of 30 or 40, as they were in the past few decades. Similarly, I don't buy the interest rate argument right now for America. But, unlike me, there are many investors who are primarily driven by relative attractiveness of stocks versus bonds. Going back to Japan, investors, particularly the locals, are happy to buy Japanese stocks at P/Es of 30. For such cases, interest rates do matter and you may consider valuations extremely attractive presently. It is quite possible that American (and other) money managers will happily pay up but it doesn't mean it's attractive for me--or you. Passive investors, whose asset allocation is not based on making valuation calls, will also pay up irrespective of valuation.

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2 Response to Graham-Dodd 10-year P/E still not low enough

January 7, 2009 at 8:36 PM

One of your better posts Siv. Good job and awesome info.

January 8, 2009 at 10:08 AM

Thanks for the compliment Alex...

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