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Subject:  Re: Evaluating a Stock with a "Higher" Date:  8/11/2008  9:54 PM
Author:  PaulEngr Number:  3671 of 3816

I still don't understand where you get this number. Could you provide a reference? One major issue is that the last 20-30 years include a very large bull market that persistently showed very high P/E ratios that will skew this number upwards. I think you have to take a much longer historical view to include at least the bear market preceding it to get a useful average.

I quote a number in the teens, then I'm going to get beat up for throwing out a low ball by those who's expectations are much more myopic. If I use a number closer to the last couple decades, I get responses like yours. This may not be the best source but here's a graphical chart of it over the last century:

Clearly, anyone drawing a line through that data and calling it an average is probably grasping at straws. If we went back 10 years, you could claim that there's been a historical increase in PE's starting sometime in the early 70's. If you look at that chart and what's going on currently, you could just as easily claim that we are now in the midst of reverting to the mean. Either way, "average" PE is clearly a subjective term, no matter how many people have researched the topic.

If you are a believer in Kondratiev cycle theory, then the last big peak corresponds roughly to the length of the last cycle. So we are now in a "trough" of sorts where your teens quotes are accurate and we can expect this to last about 10 years before things start rising again based on the new economic driver because Kondratiev cycles are roughly 55 years in length. K-wave theory suggests that using anything more than an average (or even fitting the data to a logarithmic curve) is invalid at best because the historical pattern is cycle, not stagnant. Again, probably not the best but here's a jumping off point:

If you're an "efficiency" or paradigm theorist, then we've been riding on the last sigmoidal curve of the last major paradigm shift. We're going to fumble around in the dark here for a little while before the next paradigm shift happens. The reason for the increase over time in historical PE's is simply that we've gradually improved socially or technologically, or both. Once the next paradigm shift kicks in, we can expect another boost and yet another "long term bull market" as you put it. However, it may be a while before that happens.

In addition, there is also evidence that the average PE for various sectors is significantly different. More than one economist has tried to claim that the correlation is based on the degree of market inefficiency due to barriers to entry such as government regulation...pharmaceuticals tend to have very high PE's while construction tends to be very low. If you subscribe to this theory, then any discussion about "average" PE's is almost meaningless. Sorry that I can't give you an exact reference on this one but it's late and my notes are buried in paper documents that wouldn't do any good to reference.

Anyways, my original point was to buy stocks with historically depressed PE's and sell stocks with historically over-average PE's. Here, I've got two choices. I can either bias the results based on very long term averages or try to adjust to some sort of approximation current market conditions (current conditions being those of the last decade or so, or based on averages for an industry). I choose to use an average of the last 10 years or so simply because I may not subscribe to K-wave theory or some such directly, I do believe that there are naturally occurring economic cycles and that trying to claim a flat, stagnant average for a metric like historical market average PE is foolhardy at best, and that I might tend to slightly bias my results towards industries with higher barriers to entry but that's OK since I am specifically seeking out those industries anyways as part of my other financial checks on a particular candidate to buy.
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