Friday, 26 April 2013

Is there life in the old dog yet?

I've always thought that the PE ratio is an odd concept. Why divide price by earnings when turning the calculation on its head gives you a percentage yield which you can readily compare with the dividend yield or a rate of return on bonds or bank deposits or indeed any other yield figure you can think of.

After all if you are the owner of a stock your share of the earnings belongs to you whether it is distributed in the form of a dividend, or if it is retained by the company to build the business. Your business. So why not think of it as a return on your investment.

Lets have a look at some rates of return as published by the Wall Street Journal. I'll concentrate on the Dow Jones Industrial Average. The others are there to be examined if the mood takes you. I'll focus on this year though the table also shows last year for comparison. And the forecast earnings are presented as a PE based on the current price to help you look into the future.

Yields on stocks vs. yields on bonds

The dividend yield on the Dow Industrial is 2.44%, slightly down from last year. If we invert the PE ratio (lets call it the Earnings Yield) it was 6.2%. (Just to be clear we are saying that if you held equal positions in all of the 30 DJI companies your investment would yield earnings of 6.2%. 2.4% would be distributed as dividends and 3.8% would be retained by the companies to grow their businesses.)

How does this compare to the return on bonds?

The yield on one year bonds is below 0.25% It does not compare well, does it? Even the yield on 30 year bonds at 2.9% is not very enticing. 

2.9% might look better than 2.4% but you have to bear in mind that the cash value of the bond will be the same in 30 years time and that value will have been eroded by inflation. Businesses in the DJI will have grown and at the very least will have kept up with inflation.

So if you look at that earnings yield and compare it with the return on bonds it is evident that the stock market could comfortably increase beyond its present value. Looked at this way the previous all time high does not look like such a great hurdle to jump. AS LONG AS INTEREST RATES AND BOND YIELDS STAY LOW. Government policy all over the world indicates that, for the foreseeable future they will. But be very afraid of the moment when those rates begin to rise. 

In the UK

Over here in the UK the picture is much the same. The FTSE has an average PE ratio of 14.1 which translates to an earnings yield of 7.1%. Dividend yield is 3.8%. This compares with 0.26% for a 2 year government bond and 3% for a 30 year bond. Again there is pressure which could drive the stock market higher.

Even central bankers have caught the bug

After preparing this little analysis I came across an item on Bloomberg which just goes to underline the point I am making. Here's a little extract:

Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk- averse investors toward equities.
In a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves.
“In the last year or so, I have spoken with 103 central banks on diversification,” Gary Smith, London-based global head of official institutions at BNP Paribas Investment Partners, which oversees about $649 billion, said in a phone interview. “If reserves are growing, so are diversification pressures. Equities are not for every bank tomorrow, but more are continuing down this path.”
Managers of banks’ assets are looking for alternatives to holding government bonds after efforts to stimulate growth from the Federal Reserve, the Bank of Japan and the Bank of England helped send yields near to record lows. Central banks’ foreign- exchange holdings have increased by about $8.5 trillion globally in the past decade, exceeding levels needed for day-to-day currency administration. 

The market today

Today the markets seem to be taking a breather, so far.

1 comment:

Dave said...

Good evaluation, Paul.
The market continues up today, 29/04. It certainly feels like a top with the market going up despite any bad news. May is nearly here! I certainly agree to run if there are any increases in interest rates.
I am not a trader, but plan to get more defensive with my investments in the next week--that is more gold, more short term bonds and selling covered calls.