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Generational Dynamics Web Log for 25-Mar-05
Motley Fool provides a bizarre analysis of price/earnings ratios

Web Log - March, 2005

Motley Fool provides a bizarre analysis of price/earnings ratios

I've been relentlessly critical of analysts, journalists and pundits who are brain-dead about price/earnings ratios.

The P/E ratio of a stock is the price of a share of stock divided by the company's earnings per share. Historically, P/E ratios average about 14. For the last ten years, the S&P 500 P/E index has consistently been in the 20-40 range, indicating that we're in a long-term bubble. This bubble will burst at some point when the right kind of triggering event occurs. This might happen next month, next year, or the year after, and it will result in a substantial stock market adjustment. (See my new article on the Fed for more information.)

Analysts, journalists and pundits have been in a total state of denial about this, and do almost anything to mislead readers. In December, I wrote about a Wall Street Journal article, where the reporter had computed the P/E ratio by dividing today's stock price with next year's inflated assumed earnings. This is almost a complete hoax, and shows how even Wall Street Journal reporters are pretty clueless about P/E ratios.

Well, now I've seen a new bizarre twist. It appeared in an e-mail message that investment advisors Motley Fool sent to their mailing list.

Here's the item:

A. Experienced investors often crunch a lot of numbers, taking many factors into consideration. Novices can learn these skills, but understand that even complex discounted cash flow analysis calculations are still based on assumptions and estimates. Moreover, expert investors often disagree on the fair value of specific stocks.

For beginners, one way to get an initial handle on a stock price's attractiveness is to compare its current price-to-earnings (P/E) ratio with its historical P/E range over the past five to 10 years. General Dynamics (NYSE: GD), for example, was recently trading with a P/E around 18. But a glance at its P/E's history shows that in the past decade, its average P/E has rarely topped 18 and is often in the mid-teens. This suggests that the stock may not be a bargain right now.

Well first, I'm surprised when any investment advisor mentions P/E ratios, because using them means that you shouldn't buy any stocks at the present time. Investment advisors stand to lose their income if their clients don't buy stocks, so they tend to avoid telling their clients anything that might have any hint of bad news, especially P/E ratios.

Well, the above little piece of advice is Motley Fool's bizarre way of avoiding giving bad advice.

If they were telling the truth, they would have said this: General Dynamics was recently trading with a P/E around 18, which means it's overpriced like almost every other stock, so don't buy any of them. (Full disclosure: I work as a subcontractor to General Dynamics, which has no relationship whatsoever to Generational Dynamics.)

Instead, they ask you to compare today's overpriced P/E to the stock's average P/E for the last ten years.

Look, I don't know how else to put this, but this is about the dumbest thing I've ever heard. If this represents the quality of Motley Fool's advice, I'd recommend that you stay away from Motley Fool. They're true to their name; their advice is motley, and very foolish.

Average P/E ratios skyrocketed in the late 1990s, to values close to 40. Tech stocks in particular often had P/E ratios in the 60s. These were the most overpriced stocks in an overpriced market, and these are the stocks that fell the hardest in the Nasdaq crash of 2000.

So Motley Fool's advice is essentially to favor the stocks that were the most outrageously overpriced during the bubble, the companies that were even more poorly managed than average during the bubble. Motley Fool advises you to stay away from stocks from good solid companies like General Dynamics that steered a fairly reasonable course during the bubble.

Obviously, this is just plain moronic, and it shows the quality of advice that we're seeing today. The correct advice is this: Stay away from all stocks, because almost all of them have been way overpriced for ten years now, and the stock market is due for a 50-75% correction. (25-Mar-05) Permanent Link
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Generational Dynamics Web Log for 25-Mar-05 Motley Fool provides a bizarre analysis of price/earnings ratios

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Generational Dynamics Web Log for 25-Mar-05
Motley Fool provides a bizarre analysis of price/earnings ratios