Regarding the dispute between bears and bulls over PE10 theory, the bulls claim that the CPA industry became too strict since 1990 and tightened the rules thus allegedly creating artificially low income for corporations and thus they alleged that the PE ratio is not too high. While it is true that some CPA standards have tightened in the past two decades the counter-argument to that is that since about 1990 corporate boards have aggressively implemented lucrative employee stock option programs that gave top management enormous windfalls, sometimes hundreds of millions of dollar in bonuses, if they made the stock price go up. This incentive made management get too aggressive and have too much incentive to implement aggressive accounting entries that
Valuing companies is based on analyzing their income streams and then capitalizing them. A significant problem in this is deciding what to do with amortization of goodwill from acquisitions. When a company buys another company they usually pay far more than the value of the tangible items. This excess cost is called Goodwill and is the intangible value of the company’s following of loyal customers. The reason CPAs make the acquiring company write down Goodwill is because the acquirer could overpay for it or because the customers could decide to switch to the competition. In an era of radical new disruption to business models through technology and globalization there is a risk that customers may defect and thus goodwill should
In recent years critics have tried to dispute the Shiller PE10 theory by claiming that corporate earnings in recent years have been made unfairly low because of an increase in overly strict rules imposed by CPA auditors. The theory is that one time wrote offs charged off during a recession shouldn’t be counted as a form of reduced earnings and the bullish advisors believe if these write-offs were not counted then earnings would be higher and PE ratios lower and thus stocks more reasonably priced. The problem with not counting charge offs of bad business projects is that when these projects were new they were viewed as profitable long term projects and their profits were used to calculate corporate earnings.
Today the SP at 2099 is 2% below its all-time high of 5-21-2015. If one adds in the 2% dividend then it has almost matched its total return all time high. However, if one uses the SP500 equal weighted index (the index used by the ETF RSP) the 5-21-2015 high was 83.03 vs today’s 80.43 value. Even with a 2% dividend added in the equaled weighted index would be 1.2% below the all-time high of last year. The New York composite (an index of all assets traded on the New York Stock Exchange) is 10,451 versus a high of 11,240 of 5-21-2015. The index reached a high in 7-3-2014 of 11,105, which after adjusting for inflation, was slightly higher than
The stunning increase in corporate profits in the past 25 years is without precedent and is a key reason why stocks are so high. The PE10 ratio attempts to average ten years of inflation-adjusted data to avoid being fooled by brief, unsustainable bubbles which may be due to unsustainable surges in corporate earnings. However, it seems the long period of rising earnings was able to outrun the protective nature of the PE10. The reason for this is that economic weakness since the crash of 2001 has damaged or disadvantaged the small businesses thus making it easier for big companies to grab and retain market share and to avoid ruinous price wars. The function of small business is to catch the
The complaint against PE10 is that it has rarely, signaled a buying opportunity in the past 20 years. But if one assumes that the only correct times to buy stocks was during the recessions of 2002 and 2009 then PE10 acted as a protective measure to discourage buying when stocks were overpriced. If one assumes that the May, 2015 high of 2,130 points for the SP was correct and not a bubble then I’m wrong. But if true value is somewhat more like the 1200 point estimate for the SP that some bears advocate then why bother to make the trip up to 2,130 points and hold on tight as stocks drop back down to 1,200 points? If one rejects
The first four days of 2016 were the worst ever for stocks for the start of the year. If the January effect is real then 2016 will be a bad year for stocks. (See @RyanDetrick on Twitter). And last year was the worst in 78 years to make money for stocks. Stocks dropped 4.9% the first four days of the year. The fundamentals of the domestic economy are reasonably decent if you ignore the hidden unemployment and low Labor Force participation rate. But the PE10 ratio says stocks are grossly overpriced. So even if the economy is decent the problem is that the ratio of stock price to corporate earnings (PE ratio) is way too high because people were motivated
PE10 theory implies that when stocks crash hard with a very low PE of about 10 that they have reached a capitulation phase, which is the bottom when it is time to buy. This happened in 1932 and 1982 but not in 2009. What has changed is that there is so much government and central bank stimulus that this acted to prop up stocks in 2009 preventing them from falling to 500 points for the SP index. The SP bottomed in 2009 at 666 points. Even if the low point for the bottom was artificially high in 2009 that doesn’t invalidate PE10 theory. What is very important is to avoid overpaying for stocks during a bubble and PE10
Today an article in Marketwatch was written by Francine McKenna about alleged accounting problems at Alibaba. The article points out how China based companies haven’t cooperated with the SEC about doing proper CPA audits. She wrote “… the Chinese government forbids the PCAOB from performing audit-quality inspections of the Chinese firms and their U.S.-listed company audits….” Additionally China based companies are often only available via a Cayman Islands shell company that replicates the amount of profit and is thus not the actual company. Also a shocking story was printed in the Wall Street Journal by Geeta Anand about an advisor in India who was brutally persecuted for publishing a bearish review of an Indian company.