Tuesday, January 03, 2006
P/E Expansion and Contraction
P/E Expansion and Contraction:
Last week, I showed a 50 year chart of the S&P500, focusing on the P/E over that time period. Today's chart covers the same issue, only we focus on the 1982-2000 Bull market.
Some people argue that P/E expansion wasn't all that significant; they say it was (if anything) a function of falling interest rates. In my mind, that only partially explains why multiples expand; It certainly cannot rationalize why P/Es went from 7 to nearly 50 over the course of ~20 years.
Why might the median P/E have run from 7 to 32 during the Bull market?
My explanation is Psychology: something shifted in investor sentiment that made them willing to pay more than $7 for a $1 of earnings -- much more. That change is best explained by a sentiment shift related to perceived relative Value.>
Click for larger graph
Source: Panzner
>
Most investors do not think P/E expansion as the lion's share of the market's 82-2000 gains; Instead, they credit a robust economy, technological advances, productivity gains, and (of course!) earnings improvement.
And all those elements did have an obvious impact -- by my math, they were responsible for about 25% of the performance.
But the biggest contribution these four elements had was not to the bottom line; rather, it was to investor psyches that gradually became willing to spend more per dollar of earnings than they had been. They allowed a rationalization of higher prices: Aren't stocks worth more if the economy is doing well? Doesn't technology make companies more efficient with their capital? If workers are more productive, went the thinking, than earnings will be all the more better.
Notice how squishy these thoughts are; they may be rational, but they are hardly the sort of easily quantifiable data points that makes for a dispassionate, calculating investor
Last week, I showed a 50 year chart of the S&P500, focusing on the P/E over that time period. Today's chart covers the same issue, only we focus on the 1982-2000 Bull market.
Some people argue that P/E expansion wasn't all that significant; they say it was (if anything) a function of falling interest rates. In my mind, that only partially explains why multiples expand; It certainly cannot rationalize why P/Es went from 7 to nearly 50 over the course of ~20 years.
Why might the median P/E have run from 7 to 32 during the Bull market?
My explanation is Psychology: something shifted in investor sentiment that made them willing to pay more than $7 for a $1 of earnings -- much more. That change is best explained by a sentiment shift related to perceived relative Value.>
Click for larger graph
Source: Panzner
>
Most investors do not think P/E expansion as the lion's share of the market's 82-2000 gains; Instead, they credit a robust economy, technological advances, productivity gains, and (of course!) earnings improvement.
And all those elements did have an obvious impact -- by my math, they were responsible for about 25% of the performance.
But the biggest contribution these four elements had was not to the bottom line; rather, it was to investor psyches that gradually became willing to spend more per dollar of earnings than they had been. They allowed a rationalization of higher prices: Aren't stocks worth more if the economy is doing well? Doesn't technology make companies more efficient with their capital? If workers are more productive, went the thinking, than earnings will be all the more better.
Notice how squishy these thoughts are; they may be rational, but they are hardly the sort of easily quantifiable data points that makes for a dispassionate, calculating investor
