I'm here to debunk a claim that I've been hearing from some very knowledgeable people, but this claim is not supported by the facts. I'll get to that in a minute, but first, let's set the table.
The Talking Heads
Turn on CNBC, MSN Money, or any of the major financial outlets, and throw in Barron's magazine and the Wall Street Journal while you're at it, and imagine that they are all saying that stocks are getting cheaper, or valuations have come down lately. This is an important point for investors to pay attention to because it implies that investors can be more aggressive with their asset allocation, adding to equities, buying growth stocks, momentum leaders, and accepting higher betas and P/Es. Is that justified by their argument? No.
The pundit argument
- The Forward P/E has declined by ~6% over the past quarter.
- Forward earnings estimates have risen sharply over the past quarter.
- Therefore, valuations have improved and stocks are cheaper now.
My rebuttal
- A Forward P/E falling does not mean stocks are getting cheaper.
- It's just arithmetic, not valuation insight.
- If price is flat (their assumption), and forward EPS estimates rise, then the forward P/E must fall.
- Forward earnings estimates are barely more than guesses. Analysts heavily rely on company guidance, which is in itself a guess.
- Analysts revise Forward EPS downward about 70% of the time. The average downward revision is 8%-12%.
- Estimates are also influenced by optimism bias.
Using the wrong valuation anchor
- Forward P/E is not a valuation measure. It's a ratio. It tells you nothing about whether stocks are cheap or expensive, in either absolute or relative terms.
- Valuation only improves if the Equity Risk Premium improves. ERP = Forward Earnings Yield - 10-yr Treasury Yield. (Earnings Yield is the inverse of P/E.)
- If bond yields rise at the same time earnings estimates are rising, the ERP may not improve at all. In fact, it can even get worse as estimates are rising.
Without ERP improvement, the "valuation is cheaper" claim collapses.
A falling Forward P/E can coexist with:
- Higher risk
- Lower expected returns
- A more expensive market, on a risk-adjusted basis.
The Core Principle
The ERP is the only way to say whether valuations have actually improved. Many investors miss this important measure because it's not usually talked about on financial shows because it's a little too "in the weeds" for most showrunners.
The Real Risk
I grant you that the market P/E has fallen about 6% in the past 3 months. A falling P/E is your invitation to increase your overall risk profile. But it doesn't mean that valuations have improved or that stocks are cheaper now. When someone uses forward earnings rather than trailing earnings, they are taking a giant leap of faith. They are assuming that - even though earnings are rising, investors will stand by and watch (don't buy stocks) as the P/E comes down.
That's not what they do. They buy, partly because they are underinvested, and the fear of missing out washes over them. But also partly because someone who looks and sounds like an expert said that stocks are getting cheaper.