A new mystery: Why is the P/E ratio remaining constant? - 11-Aug-05 - Generational Dynamics

If you look at the bottom of this web site's home page, you'll see a graph, automatically updated every week, of the S&P 500-stock index, and the S&P 500 stock price/earning ratio index.

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 5-Aug-2005. (Source: MarketGauge ® by DataView, LLC)

For the last several months, the P/E ratio has been constant -- around 20. As far as I can tell, going back to the 1800s, the P/E ratio has never before remained constant for several months like that.

In fact, it's been almost constant for a full year, especially when you realize that the Presidential election probably pushed the stock market up slightly, as happens in any election year.

What's the explanation? It could be a coincidence, but I don't believe a coincidence like this could go on for so long.

What it must mean is that most investors are making investment decisions based on a formula, and they're all using the same formula.

And the formula is equivalent to investing in a stock portfolio with an average p/e ratio of about 20.

Does that seem strange to you? Why should it? Do you really think that all those stock analysts think for themselves all the time? They're like everyone else -- they talk to each other, and they all do the same thing.

Actually, I think I know what formula all the stock analysts are using. Several months ago, I read a commentary somewhere that mentioned that most investors were using the "Fed Model" for investments.

I did some investigation, and it turns out that the "Fed Model" is based on one single paragraph and a graphic buried deep in the middle of a 1997 Federal Reserve report. The graphic and the paragraph are as follows:

"The run-up in stock prices in the spring was bolstered by unexpectedly strong corporate profits for the first quarter. Still, the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming twelve months has risen further from levels that were already unusually high. Changes in this ratio have often been inversely related to changes in long-term Treasury yields, but this year's stock price gains were not matched by a significant net decline in interest rates. As a result, the yield on ten-year Treasury notes now exceeds the ratio of twelve-month-ahead earnings to prices by the largest amount since 1991, when earnings were depressed by the economic slowdown. One important factor behind the increase in stock prices this year appears to be a further rise in analysts' reported expectations of earnings growth over the next three to five years. The average of these expectations has risen fairly steadily since early 1995 and currently stands at a level not seen since the steep recession of the early 1980s, when earnings were expected to bounce back from levels that were quite low."

So, from what I can gather, a sizable majority of investors today are basing their investment decisions on the "Fed Model," which is based on a single paragraph in a 1997 Fed report. It's laughable, but it's true.

Incidentally, in case you were wondering, the correlation shown in the graphic did not work prior to 1982. However, most financial analysts today are kids in their 20s and 30s, so anything before 1982 is ancient history to them anyway.

This observation that most investors and financial analysts are following the same formula ties in with something else.

In May, I wrote an article about stock market volatility. I pointed out that the stock market was getting increasingly volatile, meaning that the marketing was fluctuating wildly.

In that article, I explained that "the volatility means that individual investors are not making decisions based on individual stocks, which they do in normal times; instead, they're nervously making buy/sell decisions based on their "feeling" about where the entire stock market in going. With investors moving in unison, that means that the entire market is subject to volatility that only a single stock would have in normal times, and it means that a scare can cause a panic and a stock market crash."

When I wrote that paragraph, I didn't know what "feeling" the individual investors were getting. But now with the observation that the P/E ratios are remaining constant, we can infer that this "feeling" is based on a formula that they're all using like sheep, so they're all acting roughly in unison. And that formula is probably something close to the "Fed Model."

For some reason, some people think that stock market panics have been banished. I can't imagine why.

Generational Dynamics Web Log for 11-Aug-05
A new mystery: Why is the P/E ratio remaining constant?

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Generational Dynamics Web Log for 11-Aug-05 A new mystery: Why is the P/E ratio remaining constant?

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Generational Dynamics Web Log for 11-Aug-05
A new mystery: Why is the P/E ratio remaining constant?