Investor Jeremy Grantham is credited with predicting both the 2008 and 2000 market crashes, and he’s predicting some pretty lean times again, this time for 20 years.
For those who experienced the big falls that the stock market saw in 2000 and 2008, they might not be all that impressed by someone who has called both these reversals, because neither of them hit us with any great surprises once they were underway.
The late 1990’s saw the media filled with opinions about how we’ve run up tech stocks way too much, and that this will all come crashing down and probably soon. With the fall that came in 2008, that one came as a little more of a surprise, but once it was underway, the cat was out of the bag and we knew what was coming and that it would be nasty.
While we may want to laud those who might have seen these things coming before they happened, there is no real practical value in that, as we really can’t just be trading on guesses here and need to at least wait for these storms to show themselves.
The people who lean more toward the bearish side and especially those who are preoccupied with valuations such as Grantham are prone to making these calls whenever they see conditions they don’t like, which can include false warnings along with the ones that turn out to be valid. Grantham for instance predicted a bear market last year, and still is, even though the market has recovered so much since.
A lot of people see stock prices as being a matter of valuation, leading us to claims such as Grantham is making today, that the current market is “pricey.” The view that things are pricey comes from looking at current stock prices in relation to their earnings, where lower ratios mean underpriced and higher ones mean overpriced.
How Concerned Should We Be That Price/Earnings Ratios Are a Little High Historically?
We are currently at a ratio of around 22 times earnings, which is on the higher end historically but not overly so. We’ve been around this area for the last 3 years now, and this could be said to be the new normal, and a lot of this is determined by how much money people want to put into the stock market and nothing more.
When we look at historical averages of this price to earnings ratio, this does include numbers from completely different times. The most we could say about the difference is that people invest a lot more than they did in the old days, which isn’t all that enlightening. The connection between why this should bring down prices is left virtually unexamined though.
We do know that when earnings decline, that’s not a good thing for stocks generally, Declining earnings tend to put up price earnings ratios, but the money invested in stocks is generally not that responsive to changes in earnings. We see the price of stocks go down during these times, but not enough to compensate for the reductions in earnings.
When we actually see these P/E ratios spike, that has always been after a time where business has suffered, like we saw with the all-time record of 70.91 in 2009. The economic downturn of the early 2000s also produced a spike, this time at 46.17, but this happened in 2002. In both these cases, the spike occurred after the stock market crash, so it has little predictive value with these events, and really doesn’t have much generally either.
If we had at least a decent correlation between this ratio going to a certain level like 22 and a bear market following, then Grantham and others who think similarly may at least have a leg to stand on, but we do not. It may even seem odd that people even pay much attention to these things, and it’s very difficult to even think of a reason for this apart from a fundamental misunderstanding of the nature of price movements with the stock market.
Our Predictions Need to Be Based Upon a Solid Foundation
Whatever the source of one’s ideas though, they have to stand up to scrutiny, and deeming stocks to be pricey simply does not. This only makes sense if we assume that stock prices and valuations are strongly correlated, but we also owe it to ourselves to not just assume this but to also dare to look at how this all plays out, and when we do, we see this all fall on its face.
Grantham isn’t that clear on where he gets his numbers from that has us seeing only half the stock market growth that we have been accustomed to historically, even though this historical account does take in distant times as well as more recent and relevant ones. The historical data includes historical P/E averages as well, although it does take an understanding of why the higher ones of today exist and do so in a more sustainable way, and this all has to do with the higher participation rate we see in the market now.
We do know that these things do move in cycles, and it isn’t unreasonable at all to expect a new cycle to emerge in the next few years at least. Just saying that it happened before so it will happen again doesn’t really tell us much though, and we at least need some impetus to change this direction, something we aren’t seeing too much of as of yet.
In the very long run, our economic prosperity will indeed run out of time, as we’re essentially living on borrowed time now, and public debt will eventually rise to the point where collapse becomes inevitable. We’re nowhere near that stage now, and the eat, borrow, and be merry times can go on for quite a while longer, much longer than just the 20 years that Grantham is forecasting dimmer times for.
There is no doubt that economic growth is slowing down right now, not to worrisome levels but at least to ones that may have us re-assessing the returns we may expect from our stocks, although this doesn’t mean that we will have to get by on the 2-3% average returns over the next 20 years that Grantham predicts.
However this all ends up, it won’t be because P/E ratios are in the low 20’s that brings this on. Calling stocks pricey in the long term really doesn’t make sense, as there are no restricting limitations to this other than how much money that people want to put in or take out of stocks. Their being pricey usually just means an enthusiastic market, and whether this enthusiasm continues or not is all up to the market and has very little to do with earnings ratios.
If anything, our current P/E of 22 is a bullish sign, and since, in the absence of an earnings down trend, it just tells us that the desire to invest in stocks is an uptrend, like our going from 20 to 22 since January, this is purely good news. It is hard to imagine arguing otherwise, unless you just aren’t looking at your rationale very closely and are assuming it is valid without proper examination, which we always need.
This isn’t to single out Grantham, and far from it, as there is a whole culture based upon a big focus on stock valuation based upon earnings ratios, and somehow, these people often find themselves in positions to advise. We need to be careful who we get our advice from though and insist that it makes sense. This view simply does not.
People do not generally invest in stocks to get dividends, so the amount of these dividends relative to a stock’s price simply isn’t that important. This does matter, but doesn’t matter that much, and certainly isn’t the whole ball game here. A ratio of 22 in itself doesn’t portend a market crash or a 20-year lull, or anything close. Other things can cause such events though, and we need to keep our eye on the ball, but on the right ball, the one that is in play, and this one isn’t it.