Archives For August 2010

From page 321 of John Bogle’s book, Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*:

“In the shorter run, the irrationality in stock returns is created by the speculative element. Stock market irrationality can be measured by the ephemeral—but critical—factor represented by the stock market’s price-earnings ratio. If, following Lord Keynes [John Maynard Keynes], we use the term investment to describe the fundamental return based on earnings and dividends, we use the term speculation to describe this second determinate of stock prices: the price that investors will pay for each dollar of corporate earnings. If the power of fundamentals dominated market returns in the very long run, the power of speculation dominates market returns in the shorter run. Speculation is, ultimately, temporary and fickle. Over time, investors have been willing to pay an average of about $14 for each $1 of earnings. But if, in their optimism, they are willing to pay $21, stock prices will leap by 50 percent for that reason alone. If, in the pessimism, they are willing to pay only $7, stock prices will fall by 50 percent. The changing price of $1 of earnings creates powerful leverage indeed, but it doesn’t last forever, nor even for an investing lifetime.”

Like the post from earlier today mentioned, the reason P/E ratios are lower than normal right now is that investors are not confident about future earnings. A stock that has a P/E ratio of 10 isn’t a bargain if future earnings are lower than current earnings. But, that is short-term thinking. If, as Bogle stated in the paragraph above, the historical P/E for that particular company is 14, and the current P/E is 10, it could be a good time to buy the stock to hold for the long-term.

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I just read an interesting WSJ piece on the decline in the importance of the price/earnings ratio. P/E ratios are on the decline:

The stock market’s average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

What does that mean?

For those of you who would prefer a little background information, a P/E ratio is simply a stock’s price divided by its earnings per share. If a stock trades for $25 per share and has $1.00 per share in earnings, its P/E ratio is 25. Another way to look at it is an investor is willing to pay $25 for each $1 of earnings. Another way to look at it is to look at the inverse of the P/E ratio, which is the earnings yield. The inverse of 25 is 4% (1/25 = .04 or 4%). So, with earnings of $1 per share and a share price of $25, this stock has a earnings yield of 4%.

Is a 4% yield good or bad? It depends. It depends on the economic outlook. It also depends on the type of company. A fast-growing company with a P/E of 25 is much different than a slow-growing company with a P/E of 25. One may represent an opporuntity when the other screams overvalued.

Back to the article…

This article claims that the P/E ratio is losing its value as a valuation measure. Why? Uncertainty. When the future’s uncertain, people aren’t willing to pay as much for future earnings. A company with a low P/E ratio means nothing if future earnings are expected to grow slowly or decline further.

P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.

P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

What the article did not mention is that those time periods were excellent times to buy stocks. It would have also been an excellent time to dollar-cost average into stocks as a way to spread out the risk. Although this can be a bad thing in the interim, it could be a buying opportunity over the long run.

1. Lynn O’Shaughnessy reviews Debt-Free U. I mentioned another article about this topic last week, which you can read here.

2. Different Types of Real Estate Agents and What They Do.

3. How to Get Out of Debt – Step 10.

4. Rethinking Adjustable Rate Mortgages.

5. If you think your state is broke now, just wait until the pension bomb explodes.

6. Speaking of pensions…here are The 10 Biggest Failed Pension Plans.

7. What do you do if you have a $100,000 income but have $55,000 in credit card debt?

8. Emergency Preparedness: How Does Your Family Rate?

9. This is interesting: Stores can now refuse small credit card charges. I wonder if this applies to debit cards too?

10. Finally, here is something for those who of you who like meat: Signs of Softness.

Here is today’s Question of the Day:

What’s One Thing the Credit Crisis Taught You?

To me, I think one thing that this crisis taught me is that the government will do anything without first counting the costs of that action. The reason for this is that there really are no consequences for government leaders aside from losing their government position. When the bubble burst, they were quick to haul in all sorts of business leaders and question them as to what happened while they completely ignore their impact.

There were other things I learned too, but this was the main thing for me.

NOTE: by “government” I’m referring to both parties, as both parties played a significant role in this particular crisis.

What about you?

From Scott Burns’ The Great Migration: Lemons Into Lemonade

Get ready for one of the largest corporate migrations in history. It will happen of necessity as managements try to find ways to do things for employees without increasing payroll costs. The move will be from the expensive coasts to less expensive areas.

This is not a new idea. It has been going on for decades. But the driving force is stronger today because corporations have less pricing power. If they could find a way to make it work, they would offer a move with a pay cut that still increased the workers’ standard of living.

I can see one problem with this theory: supply and demand.

Those who live in higher priced areas of the country have higher prices because their property is in demand. If companies start moving people in droves, the housing market will become saturated and prices will have to come down, making the migration less beneficial to both companies and their employees.

It will probably work for the first movers but I don’t see this happening on a very large scale.


I was cleaning out my email inbox and found this email from way back in July:


I have a question. If a person owed money to someone in 1998, but did not repay that amount until 2010, how can he calculate what amount to return now (in 2010) considering that much inflation has taken place since 1998? Should he use the yearly CPI inflation rate for his country? Will appreciate your help. Thanks.

The amount to be paid back and the term of the loan should have been spelled out when the money was initially borrowed. Although the CPI can be used, it should be the beginning point. The person who loaned the money was out that money for the last 12 years. Paying back money with only an adjustment for the CPI is basically paying them back the original amount. To compensate them for the usage of the money, the borrower would need to include some percentage above the rate of inflation (the CPI in this case). I would say a good starting point is 2% over the CPI.

Basically, what that means is if this person borrowed $1,000 back in 1998, they should pay back around $1,726.93 at CPI +2% (or $1,351.59 just using the CPI for the last 12 years).

I hadn’t realized that it had been over three years since I last updated this graphic. What the graphic below represents is a year-by-year ranking of the ten sectors that make up the Dow Jones Total Market Index along with returns for the Total Market Index and a Portfolio composed of equal weights of each of the ten sectors. The Portfolio is rebalanced annually. These returns are for the index and not for an actual mutual fund. In other words, no transaction fees or fund expenses are deducted from these returns.

In addition to the year-by-year rankings, I also included rankings for the average annual return for each sector over the entire 18-year period. I think it’s interesting that even with the internet bubble and the housing and credit crisis, the Portolio still returned 9.08% per year. That performance put it in third place. The Lehman Aggregate Bond Fund, which appears on the Callan Periodic Table of Investment Returns, averaged 6.43% return from 1992 – 2009. That would have put it second from the bottom in the rankings (between Utililities and Telecommunications).

The numbers are a lot worse than they were in 2006. See for yourself: A Look at the Dow Jones Total Market Index Sector Performance.