The Magic of Multiples

Everyone loves a bull market. There's nothing like it to make stock pickers look smart and gloss over the odd miscue. Bull markets are about sentiment and the reason they tend to work so well is that they are driven by results and sentiment. Sometimes sentiment is the overriding factor, as in the tech bull of the late 1990's where companies commonly traded at three digit multiples. That sort of P/E regime is, of course, a sign that something is very wrong in the market. When 100 P/E multiples become the norm while risk free returns of 6-7% can be had in the T-bill market there's only one way the market can go-down. Multiples can be your friend though, if you pick your spots wisely. One thing that makes a sector an out performer is the arrival of the masses. Good news, plenty of press coverage and plethora of generalist market analysts and strategists "discovering " a sector draws more and more investment dollars. The graph of the S&P500 P/E ratio over the last 30 years shows the effects of those broad capital flows. Through the first half of the graph (up to 1990) the P/E ratio rarely exceeded 15, which was considered a pretty healthy number in the "old days". As the 1990's wore on, things started to change dramatically. The CNBC generation discovered the market and the buying that ensued dragged the P/E for the S&P as a whole to the 35 level. Some of the expansion was due to lower debt costs and risk-free rate of return which is negatively correlated to P/E multiples (i.e. lower interest rates = higher P/Es) but much of it, especially in the late 1990s was purely sentiment driven. It was buying based not on past or current profits for the companies in the index but on expectations of future profits. The second peak in 2002 is less relevant, since it's created by a profit contraction rather than a sentiment expansion. Profits dropped much faster than share prices when the bubble burst and a few quarters of corporate mea culpas and accounting "corrections" ensued. That drove the P/E ratio up in a short sharp and unhealthy spike. Since that time the markets have based and the P/E ratio as returned to a level of 20-22. This is high by historical standards and one reason many analysts view current market conditions as a bear market rally rather than a new bull market. Historically, P/E ratios drop below 10 before the market bottoms after a major top like 1999-2001. The important point to note i...

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