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Generational Dynamics Web Log for 6-Dec-04
A Wall Street Journal article with an ironic twist warns that stocks are overpriced in India.

Web Log - December, 2004

A Wall Street Journal article with an ironic twist warns that stocks are overpriced in India.

India's stock prices have increased 29% during the past six months.

India's BSE 30 stock market index, Jan-December 2004 <font size=-2>(Source: WSJ)</font>

India's BSE 30 stock market index, Jan-December 2004 (Source: WSJ)

According to the article on p. C16 of Friday's (12/3) WSJ by Eric Bellman, "The robust Indian stock market may be due for a breather, as investors wait for earnings to catch up with soaring share prices."

There's a very ironic twist to this article, because it gives as an explanation the fact that price/earnings ratio are getting too high.

How high have they gone? To an average of 15!!

According to the article, analysts are warning that the recent rally in India's stock market "might have taken prices higher than their potential earnings warrant." It says, "The 29% increase in the benchmark index during the past six months has pushed up the average price/earnings ratio for companies that make up the Sensex to more than 15, based on projected earnings for the year ending March 31 -- well above the average of 11 for the previous three-year period. The average P/E ratio based on earnings projections for fiscal 2006 is about 13, analysts say."

Wall Street Historical Price/earnings ratio for S&P 500

Wall Street Historical Price/earnings ratio for S&P 500

So the Indian stock market is in danger because P/E ratios have reached 15, but journalists, pundits and high-priced analysts are blithely sanguine about American P/E ratios in the 20s, as the adjacent graph shows.

Regular readers of this web site know how cynical I am about journalists, politicians and analysts, most of whom say any dumb thing that pops into their heads, but this whole issue of P/E ratios really takes the cake.

Go back and and reread that paragraph above where I quoted the WSJ article, where it says that the value 15 is "based on projected earnings for the year ending March 31." This computation is almost a complete hoax. Let me explain.

How do you compute P/E ratios? You take the price of the stock and divide by the earnings of the company per share of stock. So if the stock sells for $100 per share, and the company earned $5 per share, then the P/E ratio is $100/$5, or 20.

It's easy to determine the price of the stock, but what value do you use for earnings? It turns out that there are several ways of doing this, and they're all equally good, provided that you don't switch methods in midstream.

Since I'm interested in analyzing long-term trends, I use Yale Professor Robert J. Shiller's figures on his web site at http://www.econ.yale.edu/~shiller/data.htm, where he's collected annual stock market data since 1871, and very generously makes them available to the public.

Shiller computes the P/E ratios using today's stock prices and dividing by the average earnings per share value over the preceding ten years. This is the most solid method method, in my opinion, and is the best to use when you're doing long-term analyses and forecasting future values.

However, almost as good a method is using the previous one year's earnings in the P/E computation. This gives a slightly different value for the P/E index, but as long as you use that value consistently, then you get valid results. In fact, the P/E ratio chart that appears at the bottom of this web site's home page is based on the previous year's earnings.

But that's not what the article above did:

It computed the current P/E index of 15 by dividing stock prices by NEXT YEAR's projected earnings. They fudged the figures by projecting higher earnings next year, so that the P/E ratio is as low as possible.

It even says that the "average P/E ratio based on earnings projections for fiscal 2006 is about 13." Why not use earnings projections for 2010 and get a P/E ratio of 5 or 10?

But when they compare it to the average of 11 for the preceding three years, that value of 11 is based on real earnings for each of those years, not on projected earnings.

This is incredibly flaky, sloppy analysis. You cannot compare P/E ratios when you compute them in completely different ways, but that's exactly what's happening in that article.

Beware the same thing happening when pundits and analysts talk about P/E ratios for Wall Street stocks. If you hear them say, as I have heard on occasion, that current P/E ratios are around 15 or 16, then they're pulling this methodological hoax. They're using current stock prices and dividing by whatever they want to claim are next year's projected earnings.

You can use any method you want to compute earnings -- 10 year average, one year, or next year's projected earnings -- but if you want to compare today's P/E ratios to historical values, then you MUST use the same method to compute earnings in all cases you're comparing.

From the point of view of Generational Dynamics, America has entered a 1930s style Great Depression era, with stocks overpriced by 100% or more, and poised to fall by 50% within the next few years. (6-Dec-04) Permanent Link
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Generational Dynamics Web Log for 6-Dec-04 A Wall Street Journal article with an ironic twist warns that stocks are overpriced in India.

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Generational Dynamics Web Log for 6-Dec-04
A Wall Street Journal article with an ironic twist warns that stocks are overpriced in India.