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Generational Dynamics Web Log for 28-Aug-2015
28-Aug-15 World View -- Explanation of Price/Earnings ratio and Stock Valuations

Web Log - August, 2015

28-Aug-15 World View -- Explanation of Price/Earnings ratio and Stock Valuations

Discovery of decomposing corpses worsens Europe's migrant crisis

This morning's key headlines from

Discovery of decomposing corpses worsens Europe's migrant crisis

Migrant routes into Europe (Washington Post)
Migrant routes into Europe (Washington Post)

German Chancellor Angela Merkel was meeting in Vienna Austria on Thursday with leaders of the western Balkan countries -- Croatia, Serbia, Bosnia and Herzegovina, Montenegro, Kosovo, Macedonia and Albania -- to discuss the "huge challenges" the countries face in view of the huge tsunami of migrants entering Europe.

However, the meeting was overshadowed by the discovery of 30-50 corpses in the back of a truck abandoned off of a highway in Austria near Vienna.

When the police first approached the putrid-smelling truck, they thought it was just having motor difficulties. But then they discovered that there was no driver, and blood was leaking. They opened the truck and found the corpses. The truck had been parked for several days in the searing summer heat, and the bodies were so decomposed that it was impossible for the police even to determine how many there were.

Merkel said of the horrific discovery: "This reminds us that we must tackle the issue of immigration quickly and in a European spirit. That means in a spirit of solidarity - to find solutions."

Unfortunately, Europe is finding few solution. The massive influx of migrants and refugees from Syria, Iraq, Afghanistan and Africa is forcing the European Union into discussions of whether the EU has any morality.

There are two agreements under particular discussion. One is the Schengen Agreement of 25 nations that permit free travel with no visa requirements or border restrictions. Once a migrant reaches a country like Hungary in the Schengen zone, he can travel freely to any other country.

The other agreement is the "Dublin Regulation," which establishes which country is responsible for processing the asylum application. This is usually migrant's first country of entry to the EU, but this ends up placing an enormous burden on Greece and Italy.

The core problem is that hundreds of thousands of migrants are expected to enter Europe illegally this year, and the EU has no coherent policy for dealing with them, or for distributing them among member nations.

The gruesome discovery of the decomposing Austrian corpses is making it more difficult to decide exactly what the European Union stands for. Al-Jazeera and Washington Post and Schengen Agreement and Dublin Regulation

Commemorating the Kellogg-Briand pact that outlawed war

In Camelot, there's a legal limit to the amount of snow that can fall in Winter. As far as I know, the US has never made earthquakes or snowstorms illegal, but on August 27, 1928, the United States signed a pact making war illegal.

The agreement was signed in Paris. Fifteen nations signed the pact on that day in Paris. Signatories included France, the United States, the United Kingdom, Ireland, Canada, Australia, New Zealand, South Africa, India, Belgium, Poland, Czechoslovakia, Germany, Italy and Japan. Later, an additional forty-seven nations followed suit.

Did it work? I guess not.

The first major test occurred in 1931 with the Manchurian Incident or Mukden Incident, which I described a couple of weeks ago. ( "15-Aug-15 World View -- Japan's Shinzo Abe blames WW II on the Smoot-Hawley Tariff act")

Japan had signed by Kellogg-Briand pact, but still invaded Manchuria in 1931, and no other country nor the League of Nations did a thing to stop them.

Like Barack Obama and probably John Kerry, Secretary of State Frank B. Kellogg received the Nobel Peace Prize in 1929 for his work on the Kellogg-Briand pact, which made war illegal. Dept. of State

Explanation of Price/Earnings ratio and Stock Valuations

S&P 500 Price/Earnings Ratio (P/E1) Index (Stock Valuations), 1871-present
S&P 500 Price/Earnings Ratio (P/E1) Index (Stock Valuations), 1871-present

If you listen to CNBC or Bloomberg TV, then you know that they're always showing graphs, and they're always talking about stock valuations, but for some strange reason they never show graphs of stock valuations. One look at the above graph, which shows the S&P 500 Price/Earnings Ratio back to 1871, and you know why they never show it.

As the graph shows, the historic average for the P/E ratio is 14. The P/E ratio today is 21.63, which is far above the historic average. In fact, thanks to the Tech Bubble, the Real Estate Bubble, the Credit Bubble, and the Stock Market Bubble, the P/E ratio has been well above 14 continuously since 1995.

By the Law of Mean Reversion, the P/E ratio not only must fall below 14 again, it has to stay well below average to make up for the 20 years it was above average. Roughly speaking, that means it will be below average for 20 years.

How low will it go? Well, it fell to the 5-6 range three times in the last century -- in 1917, in 1949, and in 1980. That's going to happen again with absolute certainty, and that means that the Dow Jones Industrial Average will fall below 3000.

Let me go on to mention a couple of very technical points.

As I've said many times, analysts on CNBC lie constantly about stock valuations. I used to quote analysts doing this, hoping to name and shame them. (See, for example, "14-Apr-12 World View -- Wharton School's Jeremy Siegel is lying about stock valuations" from 2012.) However, these people don't shame. After Monday's 4% plunge on Wall Street, I saw one analyst on CNBC say that now is the time to buy stocks because stock valuations are the lowest in decades.

Starting in the 2000s, analysts found the best way to lie. If you listen to them, listen for the words "based on forward earnings" or "based on operating earnings." The P/E ratio is computed by dividing the stock price by the annual earnings, and the easiest way to lie is to use bloated earnings that come from a company's public relations department. "Oh yes," a company president might say, "our earnings next year will be twice as high as this year!!" If you increase the earnings, then the P/E ratio goes down.

Then to complete the lie, they refer to the historical average of 14. "Universal Widgets stock has a P/E ratio of 12, based on forward earnings, which is much lower than the average of 14!!!"

S&P 500 Price/Earnings ratio, based on one year trailing earnings, at astronomically high 21.63 on August 21 (WSJ)
S&P 500 Price/Earnings ratio, based on one year trailing earnings, at astronomically high 21.63 on August 21 (WSJ)

That historical average of 14 is only valid for P/E ratios based on "one year trailing earnings." Those are the company's earnings in the past 12 months, as actually reported in SEC filings and tax forms. They're not public relations numbers, and they're the only numbers you can count on.

If you want to use "forward earnings" or "operating earnings" to compute the P/E ratio, then you can, provided you use the correct historical average -- which I've estimated to be about 8. So if Universal Widgets stock has a P/E ratio of 12, based on forward earnings, then it's way overpriced, much higher than the historical average of 8.

One more technical note. Professor Robert J. Shiller of Yale University, who compiles the price/earnings data that I use, prefers to use "PE10", referring to the price of the stock divided by the average annual earnings for the past ten years. I prefer to use PE1 because it gives essentially the same results, and because it's easier to explain. Robert J. Shiller online data

(Comments: For reader comments, questions and discussion, see the 28-Aug-15 World View -- Explanation of Price/Earnings ratio and Stock Valuations thread of the Generational Dynamics forum. Comments may be posted anonymously.) =eod

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