On High Normalized P/E Years
While reading a post at The Confused Capitalist discussing Ken Fisher’s book, “The Only Three Questions That Count“, I started thinking about how best to discuss the risks present in high normalized P/E years.
The following quote from The Confused Capitalist lead me to write this post:
Mr. Fisher’s big opening statement in his book challenges a long-held market axiom that high PE’s denote reduced returns for some period of time into the future. He states that the year immediately following a high PE year has virtually no statistical inverse correlation. While this might be true, it ignores the fact that there is heightened risk of a reduced return into the relatively near term future. Whether that lower return is realized in the immediate year following, Mr. Fisher’s data suggests, no.
However, an investor (rather than a “speculator” or “trader”) would be foolish to ignore the reduced odds of outperformance that this period provides.
After reading this, I decided I had to write a post directly discussing the risk present in extraordinarily high normalized P/E years – because such years are riskier than most years.
I don’t mean to say that an intelligent investor (or more likely trader) can never have a good reason for buying during an obviously expensive year. I do, however, mean to say that anyone who blindly assumes the risks present in an expensive year are comparable to the risks that were present during a typical year in the 20th century is operating under a dangerous delusion.
Furthermore, while I prefer to focus on the long-term, I can not allow others to unthinkingly entertain the pleasing notion that the ill effects of high normalized P/E years are only felt in the long-run. The evidence directly contradicts this particular delusion. A one-year bet on the Dow during a high normalized P/E year is a risky bet quite unlike a one-year bet on the Dow in any other year.
For those who haven’t read my series on normalized P/E ratios, let me explain how I worked with the data. I measured compound annual point growth in the Dow based on yearly averages for that index. For the sake of simplicity, dividends were ignored entirely – obviously, this omission benefits high normalized P/E years and serves to downplay the normalized P/E effect, because low normalized P/E years tend to have high dividend yields while high normalized P/E years tend to have low dividend yields. For a description of how I calculated normalized P/E ratios read “On Calculating Normalized P/E Ratios“.
With that explanation out of the way I can turn to the issue raised by The Confused Capitalist. Remember, I’m using 15-year normalized P/E ratios which differ somewhat from the P/E ratios you read about on a daily basis. Occasionally, the difference is quite large.
The poster child for such differences between P/E ratios and normalized P/E ratios is 1982, a year with a fairly ordinary looking P/E ratio of 14.26 but an absurdly low normalized P/E ratio of 6.88 – which just happens to be the lowest normalized P/E ratio on record. With the benefit of hindsight, we now know 1982 was a good year for long-term investors to buy into the Dow – so score one for normalized P/E ratios.
Of course, there’s nothing magical about the 15-year normalized P/E ratio. It’s just an indicator of cheapness. In 1982, the Dow’s price-to-book ratio was also screaming “buy”. When something’s really cheap it tends to look cheap from a lot of different angles.
The angle I chose for this discussion is the 15-year normalized P/E ratio. I began by selecting the year with the highest normalized P/E ratio from each decade for which I have a full ten years to work with. That limited me to just six years – one from each decade from 1940-1999.
For the purposes of comparison, I also selected the year with the lowest normalized P/E ratio from each decade. This left me with two groups of six years each, a low normalized P/E group and a high normalized P/E group.
The low normalized P/E group had an average 15-year normalized P/E of 10.26 vs. 18.31 for the high normalized P/E group. The difference in average actual P/E ratios was somewhat smaller, 11.80 vs. 16.59. The difference in average price-to-book ratios was also quite large, 1.28 vs. 2.58. However, the difference in median price-to-book ratios was a bit smaller, 1.06 vs. 1.94.
Was there a noticeable difference in one-year performance between the two groups?
Yes. The six low normalized P/E years posted an average point gain of 17.76% while the six high normalized P/E years posted an average point decline of 3.81%. All six low normalized P/E years experienced point growth while five of the six high normalized P/E years experienced a point decline.
The very best performance among the six high normalized P/E years was a gain of 2.38%, while the very worst performance among the six low normalized P/E years was a gain of 5.57%. In other words, none of the six high normalized P/E years managed to outperform any of the low normalized P/E years.
All of this happened despite the fact that the low normalized P/E years averaged an earnings per share decline of 1.49% while the high normalized P/E years averaged EPS growth of 18.99%.
Five years out, their positions were reversed as the compound annual EPS growth of the two groups over a five-year period favored the low normalized P/E years, 9.77% vs. 5.18%.
These last two facts help explain the low normalized P/E effect. It’s not just about cheapness – it’s about mean reversion and illogical expectations running headlong into the brick wall of reality. As a result, high normalized P/E ratios are a sign of serious risk and strong earnings growth (even 19% a year) is no guarantee of safety. In fact, in the extreme years we looked at in this post, earnings declines were three times more likely among the group that posted great one-year returns.
For those curious about interest rates – yes, the low normalized P/E years did have a higher average interest rate than the high normalized P/E years. The two groups had AAA bond yields of 7.07% and 5.83% respectively.
As you’ve probably come to expect by now, the low normalized P/E years also saw stronger point growth over longer time periods than the high normalized P/E years. It was 17.76% vs. (3.81%) over one year, 10.63% vs. (0.99%) over three years, 11.85% vs. 2.38% over five years, 10.87% vs. 4.79% over ten years, and 9.67% vs. 5.16% over fifteen years.
So, at least according to this small group of twelve extreme years taken from six different decades, especially high normalized P/E years are especially risky and long-term investors aren’t compensated for those risks in later years. In fact, both in the short-term and the long-term, buying the Dow in expensive years tends to lead to more risk and less reward than buying the Dow in cheap years.
Not exactly a shocking conclusion.
Related Reading
On 15-Year Normalized P/E Ratios for the Dow
On Normalized P/E Ratios and the Election Cycle
On Normalized P/E Ratios and the Election Cycle (Again)
On Normalized P/E Effects Over Time
On Calculating Normalized P/E Ratios
On the Difference Between Actual Earnings and Normalized Earnings
On the Dow’s Normalized Earnings Yields for 1935-2006
In Defense of Extraordinary Claims
On Normalized P/E Ratios Over Six Decades
I’ll have many more posts on this project in the days ahead. If you have any questions (or suggestions) about this project, please feel free to comment to this post – or, simply send me an email.