Mr. Market And The Upside Down PE-An Update

Wrote the following a ways back and time for an update.  For a refresher, the upside down PE is the Forward Earning Yield which is 1 divided by the PE.  Example:  if a stock has a PE of 20 than 1 divided by 20 equals a Forward Earning Yield of .05.  Or 5%. Just as a bond pays .o4, or 4%.  The details are below in the previous post.  This is an update. 

The relevant question is Do Relative Valuations Remain Attractive?

The answer is Yes.

Here they are.

                                                       World     US        UK     Japan     France     Germany       

Forward Earnings Yield       7.19%    6.99    8.41   5.68         8.06            8.18

10 Year Gov't. Bond              3.88        4.63    4.52   1.68         3.72            3.71

Yield Spread                             3.31        2.36    3.88   4.00        4.34            4.47

Source:  Thomson One Analytics  9/30/2006

Given these spreads stocks are more attractive than bonds.  The spread is about the same as at the market bottom of 2003 which indicates a healthy market for equities.  The spread is even better for foreign markets.

Is this the only indicator?  Obviously no but it's a pretty good one.

Previous Post

I spent one summer awhile back at the Stanford University Senior Executive Program, summer school for executives.  Class in the morning, golf in the afternoon and casual dinners in the evening.  180 men and 15 women that made for some interesting interpersonal dynamics that we won't go into here.

There was a pretty good finance professor and he talked and talked about Mr. Market.  Mr. Market sets the prices, knows everything, and is rational.  At least most of the time he is rational.  Every once in awhile there is a thing like the dot.com bubble but those evaporate after a bit.  Well, what is Mr. Market then?

Mr. Market is the investment cash in the world looking for returns.  Mr. Market can buy anything--stocks, bonds, CDs, pork bellies, wheat, corn, currencies, Persian rugs, real estate, gold, silver, classic cars or just bits and pieces of all these and more. 

And what attracts Mr. Market?  Return, pure and simple.  And liquidity or the ability to quickly buy or sell an asset.  Mr. Market is looking to make money on his investment and the ability to turn the asset into cash quickly.

So all these assets compete with each other for the attention of Mr. Market.  And how does Mr. Market decide to buy or sell?  Just like you do when you go to the grocery store.  You look for the best value for best price and so does Mr. Market and so he compares prices.

What prices?  For the sake of keeping it simple, let's compare stocks and bonds.  Mr. Market is big on these because they are liquid, easy to get into and out of. 

And bonds are easy.  If a one year bond pays 4% that means you put down $1,000 and one year later you get (assuming the bond issuer doesn't go bankrupt) your $1,000 back and $40 in interest.  But what do you get from the stock?  You don't know.  It may pay a dividend but may not.  So how does Mr. Market value a stock?

He looks at the PE or price earnings ratio.  If a stock has a price of $100 and makes $5, it has a PE of 20, or $100 divided by $5 equals 20.  So you compare a bond yield of 4% and the PE of 20.  Wait a minute, that doesn't work.  That's right so Mr. Market reverses the math and divides 1 by 20 and gets a yield of 5%.  And in this case the yield on the stock at 5% is higher than the bond yield of 4% so Mr. Market should buy stocks. 

Will he?  Maybe, maybe not.  There are tons of other factors but when the inverse of the PE ratio is higher than the bond yield, stocks are a buy.  Like now.

Because the forward PE ratio is about 6% and the 10 year bond yield is about 4.5% for a positive spread to stocks of 1.5%.  Which is huge but this is in the United States.  The spread is even bigger overseas at 3.25% in Japan and over 4% in France.  France?  Yes, France.  I'm not recommending French equities right now but it does point to another rule of finance--the higher the perceived risk, the higher the required return.

Back to PE's and yields.  So you should buy stocks when the PE inverse is above the bond yield.  Not necessarily but it is a really positive sign for stocks.

Actually you should consider stocks even when the PE is BELOW the bond yield because stocks have potential, bonds don't if held to maturity.  You plunk down $1,000 for a bond paying 4% you will get $1,040 in one year.  If you buy a stock with a PE inverse ratio of 5% you are buying a piece of a company and if the company gets really good results that stock could really take off earning you way in excess of 5%.  Bonds have return, stocks have potential.

And Mr. Market is in the market for potential.

   

Comments

[jimmy]

umZsKl fw831f64td9glse934dkjga

[Margot]

"interesting interpersonal dynamics" Nicely put. I see you also forgot to mention your themed parties. How frat-tastic of you boys.

[Neo's Nest Egg]

I am sorry for the delay in getting this released. Your submission has been included in this week's Festival of Frugality at the following URL:

http://neos-nest-egg.blogspot.com/2006/03/festival-of-frugality-14.html

Neo