The Great Compression

Posted on 02.20.12 by Michelle Rand in Investment

A stock’s price/earnings ratio describes how much an investor pays for that company’s earnings. The math is simple: it’s the price of the stock divided by recent earnings per share. If the stock price is $20 and the earnings are $2, then the PE is 10. In this case, an investor is paying $10 for every one dollar the company has earned. Value investors prefer to pay less for earnings rather than more, so a PE of 10 is more attractive than a PE of 20. A dollar is a dollar, after all, and we don’t much care who’s earning it.

Over the last twelve years, PEs have compressed, big time. In the late 1990s, the average PE of the market was over 30. That is stupendously high, as the average PE over several decades has been just 16. Now, part of the reason the market PE was so high was because technology stock valuations were beyond unreasonable. But many mundane stocks have suffered, too.

This compression has happened two ways. First, stock prices are down or at best, flat. Second, earnings have increased. Here are a couple examples:

  • Intel. Earnings were $1.53 in 2000. The stock’s high was $76; its low was $30. Fast forward to 2011: the company is now earning $2.31 – about 50% more; but its stock price ranged between $19 and $26 in 2011. Why are investors willing to pay so much less for Intel’s stock, even though its earnings power is so much greater now than ten years ago?
  • Ok, ok, so that’s a tech stock. Special case. How about something falling into the “mundane” category? Emerson Electric earned $1.65 in 2000 and its stock price averaged $30 during the year. Now, it earns $3.24 – 96% more than back then – but the stock sells at $51.50. Why isn’t it closer to $60?
  • Kroger. Earned $1.34 back in 2000. Average stock price was $21. Now, Kroger earns $2.00 – that increase is about the same as Intel’s 50%. But Kroger is barely hanging onto a $24 stock price. Why isn’t it $30?
Not mentioned here is the fact that all these companies have raised their dividends handsomely in the last several years, so not only do you have the benefit of higher earnings power, you’re also receiving more cash into your pocket from owning the shares.
PE compressions happen after periods of overvaluation. It’s as if the market must recover from all that excess – like a multi year hangover. Additionally, one can find all sorts of reasons to dislike stocks right now: politics, poor economies, general uncertainty, and so forth. But those reasons always exist. The real question is: what makes people decide to “like” stocks again? Why did the market take off in the summer of 1982, not to look back in any substantive way for over a decade? Why not 1981? or 1983?
The market was cheap in 1982. It was also cheap in 1981 and 1983. The triggers for a bull market are complicated and no one really understands them. But one trigger is cheapness, no doubt about it. The longer earnings continue to progress without commensurately higher stock prices, the cheaper the market will become, and the closer we will come to another bull market.