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High Price/Earnings Ratios and the Stock Market: a Personal Odyssey

After forty years of banking and investments, I retired in 2001. But since I don’t play golf, I quickly found retirement very boring. So I decided to return to the investment world after ten months. However, those ten months were not a total waste of time, as I had spent them trying to use my forty years of investment experience to gain some perspective on the latest stock market “bubble” and the “crash” that followed.

Many people saw the stock market crash coming, but they had different ideas about when it would happen. Those who were too early had to endure the derision of their peers. It was difficult to take a stand when so many people were proclaiming that we were in a “new era” of investing and that the old rules no longer applied. From the start of 1998 to the market high of March 2000, of 8,000 stock recommendations by Wall Street analysts, only 29 recommended

“to sell.”

I am known for calling for a cautious approach to investing two years before the “Crash of 2000”. In an internal investment newsletter dated April 1998, I have a photo of the “Titanic” with the caption: “Does anyone see icebergs?

When I returned to work in 2002, I happened to glance at the chart on the last page of Value Line, which showed that the stock market had peaked, coincidentally, in April 1998, at the same date than my “Titanic” newsletter! The Value Line Composite Index peaked at 508.39 on April 21, 1998 and has been lower EVER! But on the front page of the same issue, the date of the market high was “5-22-01”! When I contacted Value Line about this discrepancy, I was surprised to learn that they had changed their method of calculating the “market tops” index from “geometric” to “arithmetic”. They said they would change the name from the “composite” value line index to the “geometric” value line index, because that is how it has been calculated over the years. Currently, Value Line is showing a recent market low on 10-9-02 and the most recent market high, based on this new “arithmetic” index, on 4-5-04, ANOTHER ALL-TIME HIGH ! If they had stayed with the original “geometric” index, the all-time high would still be April 21, 1998!

Later that year, I was pleasantly surprised to read in “Barron’s” an interview with Ned Davis, of Ned Davis Research, who said that his indicators had resumed the beginnings of the bear market in April 1998, the same date as my “Titanic” newsletter! So my instinct was correct! I believe we are in a “secular” recession that began in April 1998 and that the “bubble of 2000” was a market rally in what was already a long-term bear market.

Another development occurred shortly after I resumed employment in 2002. I happened to notice one day that, in its “Market Laboratory”, “Barron’s” had inexplicably changed the P/E ratio of the S&P 500 to 28.57 against 40.03 the previous week! This was due to a change in “operating” profit of $39.28 from the “net” or “reported” profit of $28.31 the previous week. Others and I wrote to “Barron’s Mailbag” complaining about this change and disagreeing, as these new P/E ratios could not be compared to historical P/E. “Barron’s apparently accepted our arguments and about two months later reverted to using ‘reported’ earnings instead of ‘operating’ earnings and revised S&P 500 data to show a P/E ratio of 45.09 compared to 29.64 the previous week.

But a similar problem occurred the next day in a sister publication to “Barron’s”. On April 9, 2002, “The Wall Street Journal” released a new format that included, for the first time, charts and data for the Nasdaq Composite, S&P 500 Index, and Russell 2000, in addition to its own three indices Dow Jones. . The P/E ratio for the S&P 500 was given at 26, down from the 45.09 now found in “Barron’s.” I wrote to the WSJ and after much correspondence they finally accepted my argument and on July 29, 2002 changed the P/E ratio for the S&P 500 from 19 to 30! I had given them examples of where some financial writers had inadvertently confused “apples” with “oranges” when comparing their P/E of 19, based on “operating” earnings, with the long-term average P/E of 16, based on “declared” income.

Because I started being cautious about investing as early as April 1998, since I thought the stock market’s price-earnings ratios were dangerously high, I was not personally affected by the “Crash of 2000 “and tried to get my clients into less aggressive and more liquid positions in their investment portfolios. But the pressures to follow the market were enormous!

Price/earnings ratios do not allow us to “time the market”. But comparing them to past historical performance allows us to tell when a stock market is high and vulnerable to a potential correction, even though others around us may have lost their bearings. High P/Es alert us to the need to be cautious and adopt a cautious approach in our investment decisions, such as a renewed focus on dividends. Very high P/Es usually indicate that a long-term bear market may ensue for a very long time. We are apparently in such a long-term bear market now. But to determine if the market is high, we need to be vigilant about the data we hear from members of the financial press, so that we can compare “apples” to “apples”. When financial information does not appear to be correct, we as financial analysts owe it to the investment community to challenge that information. This is what I concluded from my personal “odyssey” in the investment world.

After three years of closing the DJIA and S&P 500 below their previous year-end figures, the market finally closed higher at the end of 2003. But the P/E ratio is still high for both indexes.

Does anyone see icebergs?

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