{"id":37927,"date":"2016-03-23T09:46:23","date_gmt":"2016-03-23T13:46:23","guid":{"rendered":"http:\/\/www.ino.com\/blog\/?p=37927"},"modified":"2016-03-23T09:46:23","modified_gmt":"2016-03-23T13:46:23","slug":"wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations","status":"publish","type":"post","link":"https:\/\/wwwtest.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/","title":{"rendered":"WSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations"},"content":{"rendered":"

\"Adam<\/p>\n


<\/p>\n

The WSJ Morning MoneyBeat blog post<\/a> for Tuesday, March 22, was entitled, \u201cEnergy Stocks Are the Most Expensive in S&P 500.\u201d<\/p>\n

Are they really?<\/p>\n

As I read the WSJ\u2019s post, I decided I really have to use this as an opportunity to help dispel some widely \u2013 nay, almost universally held \u2013 notions about using P\/E ratios to predict stock price movements. <\/p>\n

How Not To Use P\/E<\/h2>\n

Almost all investors, in my experience, routinely fall into the trap of misusing the P\/E. In fact, I admit I fell into the same bad habit for many years myself. Until a couple of years ago (more on that later).<\/p>\n

Don\u2019t get me wrong. It\u2019s not that the ratio can\u2019t be useful. On the contrary, when properly interpreted, P\/E can be an indication of sentiment, which is always important for an investor to understand. When P\/Es are low (remembering to mentally adjust absolute P\/E figures to account for differences in interest rates, inflation, and other market conditions in order to accurately assess whether P\/Es are truly \u201clow\u201d or not), sentiment is probably somewhat sour, generally speaking. High P\/Es (all things considered) generally mean investors feel willing to \u201cpay up\u201d for earnings, growth, dividends, and\/or other perceived benefits of owning stocks. And again, having a feel for what the market\u2019s sentiment is can be helpful (often in a contrarian sort of way).<\/p>\n

Beyond the ratio\u2019s use as a rough sentiment gauge, however, I\u2019ve learned several things in the last couple years about using (or misusing) P\/E ratios (for individual stocks and for the broad markets), which I\u2019ll summarize as follows:<\/p>\n

\u2022 In the short-term (1-3 years or shorter), P\/E ratios have very little (if any) correlation<\/strong> to price movements.<\/p>\n

\u2022 In the short-term, P\/E ratios almost absolutely do NOT cause<\/strong>, explain<\/strong>, or predict<\/strong> price movements. (Note: causation is different than coincidental correlation).<\/p>\n

\u2022 In the long-term, P\/E ratios STILL have very little correlation<\/strong> to price movements.<\/p>\n

\u2022 In the long-term, P\/E ratios STILL cause<\/strong> or explain<\/strong> only a small fraction of price movements. In other words, other factors are much more responsible for price movement than is the P\/E.<\/p>\n

\u2022 Bottom line, you really can\u2019t use P\/E to predict price movements, either in the short term or the long term! Again, P\/E\u2019s only usefulness is as a rough gauge of sentiment.<\/p>\n

Now, most people know \u2013 cognitively, at least \u2013 P\/Es don\u2019t help predict stock movements in the short term. I always knew that as well. But until a couple of years ago, I still often found myself getting sucked into the trap of overly relying on P\/Es predict short-term price movements anyway! I don\u2019t do that anymore. But (no thanks to the media, I think), I see many investors still falling into the same old trap!<\/p>\n

My Catharsis \u2013 How I Learned (The Hard Way) To Properly Use P\/E Ratios<\/h2>\n

After the Crash of 2008, I thought I was being really smart to recognize that each of history\u2019s major, multi-year bull markets had started with a P\/E below 9. So, since the 2008-\u201909 market P\/E never descended to those extreme levels before proceeding to rise higher, I made a mistake in my own investments and in my investment advisory practice. I made a big, overconfident bet that 2009\u2019s recovery would not be a lasting one, nor would it lead to a bull market. I truly felt, in my infinite wisdom (pshaw!) that I was being smart enough to NOT use P\/E to predict short-term prices because I knew that would be ineffective. Rather, I simply felt (quite smugly) I\u2019d eventually be proven correct in the long-term. I believed any bull run would be ultimately wiped out by a crash bigger than 2008, based primarily on my confidence in not only the P\/E, but in Nobel laureate Robert Shiller\u2019s \u201ccyclically adjusted price-to-earnings\u201d (CAPE) ratio.<\/p>\n

Of course, being too conservative throughout the US market\u2019s bull run from 2009-2014 was quite an uncomfortable position to be in! Especially in 2013!<\/p>\n

Then I read Ken Fisher\u2019s New York Times best-selling book, The Only Three Questions That Still Count: Investing By Knowing What Others Don\u2019t. (As an aside, I highly recommend the read. A handful of books can almost be considered an investing Bible. This, to me, is one of those). <\/p>\n

In the book, Fisher specifically addresses \u2013 head-on \u2013 the very fallacies to which I had fallen prey; namely, Shiller\u2019s CAPE, and even more broadly, the pitfall of using P\/E ratios to predict long-term stock prices. <\/p>\n

In the interest of brevity, I\u2019ll refer you to Fisher\u2019s book for the statistical and historical proofs. He does a masterful job of tearing apart the myths. So I\u2019ll simply move on to the WSJ blog I referenced earlier, as a way to illustrate the current debate over energy-sector P\/Es. In the end, I welcome your comments, feedback, and experiences as well.<\/p>\n

Will Today\u2019s Energy Sector P\/Es Be Predictive Of Future Returns?<\/h2>\n

In this last section of today\u2019s article, I\u2019ll quote excerpts from the WSJ blog post, then insert my comments (labeled AF, as in my initials). I\u2019m taking the WSJ\u2019s excerpts in the order they appear in the WSJ\u2019s article. Here goes:<\/p>\n

WSJ: \u201cEnergy companies have the highest trailing price-to-earnings ratio of any sector in the S&P 500.\u201d<\/strong><\/em><\/p>\n

AF: Okay, so we\u2019re talking about \u201ctrailing\u201d P\/Es, meaning we\u2019re looking backward over the last 12 months. Not only are P\/Es not predictive, but \u201ctrailing\u201d P\/Es are even worse. Why? Because (quite simply) the stock market is forward-looking, not backward-looking. What do earnings from April 2015 have to do with returns from April 2016 to April 2017? Very little, if anything. Per Fisher, markets tend to look about 18-24 months ahead, or perhaps sometimes as high as 36 months. Markets never look backward, though.<\/p>\n

Note, this same logic extends (even more so) to Shiller\u2019s much-hyped CAPE ratio, which uses earnings over an arbitrary 10-year trailing basis. Which leads to the even more preposterous question, what do earnings from as far back as April 2006 have to do with returns from April 2016 to April 2017? Answer: absolutely nothing! Yet Shiller\u2019s ratio actually uses data from 10 years ago in its denominator, as an arbitrary \u201csmoothing\u201d method. Very bizarre, if you think about it!<\/p>\n

Note further that Fisher points out even Shiller\u2019s own original paper admits only about 40% of the variability in long-term stock prices is statistically explained by CAPE. Meaning 60% or so of long-term prices are determined by factors other than CAPE. I wish I had known that before making my overconfident decision in 2009 to bet on a big double-dip. Price matters, but so do many other important factors \u2013 especially when prices are within a reasonable range. At the extremes (i.e., Black Swans, spikes, bubbles, etc.), I reckon, prices do matter more than usual. The trouble is, though, it\u2019s very tough to know when the \u201cextremes\u201d are at their most extreme. Case-in-point: energy stocks today. Have we hit bottom, or is a huge double-dip coming? (I don\u2019t know).<\/p>\n

And finally note (last one): For all the limitations of backward-looking \u201ctrailing\u201d earnings data in P\/E\u2019s denominator, forward P\/Es are problematic in their own right, because forward earnings are (by definition) not yet known. Still, I\u2019d prefer to use a good, thoughtfully calculated forward-looking P\/E as a sentiment gauge, as long as the ratio is taken with a large grain (or two) of salt.<\/p>\n

WSJ: \u201cA P\/E ratio can increase as share prices rise or earnings decline. For energy, it\u2019s both.\u201d<\/strong><\/em><\/p>\n

AF: So, the WSJ is saying energy stock prices have been rising? Sure, a tad bit recently, I suppose. In the next paragraph, the WSJ quantifies all this, as follows: \u201cThe S&P\u2019s energy sector has advanced 5% so far this year as crude-oil prices have rallied.\u201d <\/p>\n

I\u2019d hardly call that \u201crising share prices,\u201d after the 40% decline in the Energy Select Sector SPDR ETF (XLE) from June 20, 2014, through December 31, 2015. XLE was once $100 per share before beginning its slide all the way to $50 on January 20th. It\u2019s now $63, which is quite a 2-month bounce! But not an explanation for why energy\u2019s P\/E is higher than the market P\/E.<\/p>\n

As for whether energy companies\u2019 earnings have been declining, well of course they have. As the WSJ says, \u201cThe sector\u2019s fourth-quarter earnings tumbled nearly 73%, according to FactSet.\u201d Yes, and history shows that trailing P\/Es can be even less predictive in the midst of massive earnings crashes like this one, when you see some truly bizarre trailing P\/E figures (more on this in a moment).<\/p>\n

WSJ: \u201cThe stretched valuations reflect investors\u2019 expectations that the worst is over for the energy sector, but also makes the stocks vulnerable to a sharp pullback if commodity prices fall again, or investors rush to sell expensive holdings if the market cools.\u201d<\/strong><\/em><\/p>\n

AF: The part about \u201cstretched valuations\u201d reflecting investors\u2019 expectations probably has some truth to it. Again, P\/Es can reflect sentiment. So what could high energy P\/Es be telling us in this case (if in fact appropriately measured P\/Es are truly high)? Well, if investors believe the worst is over, perhaps investors aren't pessimistic enough for a true bull to begin. Remember, \u201cBull markets are born on pessimism,\u201d John Templeton said. High P\/Es could imply investors aren\u2019t yet pessimistic (or capitulatory) enough\u2026 and on this point, I would tend to believe the WSJ may be correct. Anecdotally, to me, it still seems to me too many investors are \u201cin there\u201d trying to \u201cbuy the dips\u201d in energy stocks.<\/p>\n

But...<\/p>\n

Do high P\/Es necessarily \u201cmake stocks vulnerable to a sharp pullback\u201d? No! Remember my catharsis?! This is the whole point. Since when can P\/Es explain or cause short-term price movement? Since never! Stocks and markets with high P\/Es routinely stay high (and continue higher) for years! And vice versa. P\/Es are not a predictor, particularly not in the short-term. They\u2019re just a very rough sentiment gauge.<\/p>\n

WSJ: \u201cIn the meantime, (the higher P\/E) shows investors\u2019 renewed appetite for risk, a trend that has pulled major indexes back from multiyear lows hit last month.\u201d<\/strong><\/em><\/p>\n

AF: Okay, now you try. Could the WSJ be correct that higher P\/Es show investors\u2019 renewed appetite for risk? I\u2019d say yes, to the extent P\/Es have gone higher recently, those higher P\/Es might reflect increased risk appetites, as \u201crisk appetite\u201d is a sentiment. That\u2019s how you use P\/E. <\/p>\n

However...<\/p>\n

Did the \u201ctrend\u201d for renewed risk appetite indeed pull major indexes back from multiyear lows, as the WSJ asserts? Well, I don\u2019t see how, since the WSJ is saying energy P\/Es were low last month. If P\/Es were low, then there was no \u201ctrend\u201d of renewed risk appetite when the rally began. Thus, the \u201crisk appetite\u201d sentiment wasn\u2019t reflected in P\/Es until after the rally. P\/Es are not a predictor. At best, they\u2019re a snapshot of concurrent sentiment.<\/p>\n

WSJ: \u201cEnergy companies in the S&P 500 trade at 38.8 times the past 12 months of earnings as of Friday, according to FactSet. That\u2019s sharply higher than the sector\u2019s average price-to-earnings ratio of 13.1 over the last 10 years. On Dec. 31, the sector traded at 21.8 times the past year of earnings.\u201d<\/strong><\/em><\/p>\n

AF: Holy smokes. These trailing P\/Es are all over the map! As I mentioned earlier, the insanely volatile \u201cearnings\u201d data in the denominator render trailing P\/Es basically useless right now, in the energy sector particularly.<\/p>\n

Another point: How many investors would have considered the energy sector\u2019s 21.8 P\/E on 12\/31\/2015 to be \u201ccheap\u201d? Not many, since the market\u2019s trailing P\/E has recently been stuck around 18. Yet the WSJ opines that investors \u201chave been pouring money into what had been the market\u2019s most beaten-down sectors,\u201d including energy. Using their logic, how was energy one of the most beaten-down sectors if it had a higher-than-market P\/E?<\/p>\n

Now, of course, I understand the WSJ is really saying the energy sector was the most beaten down in terms of absolute price declines, not in P\/E. But this still contradicts the assertion energy stocks' February P\/Es could have in any way predicted price movement. If anyone thought P\/Es to be predictive in the short term, last month just disproved the notion! Else, why would a sector with a 21 P\/E outperform the market, with it's 18 P\/E?<\/p>\n

Conclusion<\/h2>\n

I don\u2019t mean to bash the WSJ. I read the Morning MoneyBeat blog almost every day. I just hope my insights here can help illuminate the error of using P\/Es to predict stock performance. Hopefully, you\u2019ll be able to kick the habit, as I have.<\/p>\n

Best,
\nAdam Feik<\/a>
\nINO.com Contributor - Energies<\/p>\n

Disclosure: At the time of post publication, this contributor owned Enterprise Product Partners (EDP), but did not own any other stock mentioned. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

The WSJ Morning MoneyBeat blog post for Tuesday, March 22, was entitled, \u201cEnergy Stocks Are the Most Expensive in S&P 500.\u201d Are they really? As I read the WSJ\u2019s post, I decided I really have to use this as an opportunity to help dispel some widely \u2013 nay, almost universally held \u2013 notions about using […]<\/p>\n","protected":false},"author":17,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[6920],"tags":[6923,8363,8362,7068,1832],"class_list":["post-37927","post","type-post","status-publish","format-standard","hentry","category-ino-com-contributors","tag-adam-feik","tag-cape-ratio","tag-energy-sector-wall-street-journal","tag-pe-ratios","tag-stocks"],"yoast_head":"\nWSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations - INO.com Trader's Blog<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"WSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations - INO.com Trader's Blog\" \/>\n<meta property=\"og:description\" content=\"The WSJ Morning MoneyBeat blog post for Tuesday, March 22, was entitled, \u201cEnergy Stocks Are the Most Expensive in S&P 500.\u201d Are they really? 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As I read the WSJ\u2019s post, I decided I really have to use this as an opportunity to help dispel some widely \u2013 nay, almost universally held \u2013 notions about using […]","og_url":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/","og_site_name":"INO.com Trader's Blog","article_publisher":"https:\/\/www.facebook.com\/inocom\/","article_published_time":"2016-03-23T13:46:23+00:00","author":"Adam Feik","twitter_card":"summary_large_image","twitter_misc":{"Written by":"Adam Feik","Est. reading time":"11 minutes"},"schema":{"@context":"https:\/\/schema.org","@graph":[{"@type":"Article","@id":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/#article","isPartOf":{"@id":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/"},"author":{"name":"Adam Feik","@id":"https:\/\/www.ino.com\/blog\/#\/schema\/person\/9651c98dd6f2629f763e85d23af3b50b"},"headline":"WSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations","datePublished":"2016-03-23T13:46:23+00:00","dateModified":"2016-03-23T13:46:23+00:00","mainEntityOfPage":{"@id":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/"},"wordCount":2253,"commentCount":0,"publisher":{"@id":"https:\/\/www.ino.com\/blog\/#organization"},"keywords":["adam feik","CAPE Ratio","Energy Sector Wall Street Journal","PE ratios","stocks"],"articleSection":["INO.com Contributors"],"inLanguage":"en-US","potentialAction":[{"@type":"CommentAction","name":"Comment","target":["https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/#respond"]}]},{"@type":"WebPage","@id":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/","url":"https:\/\/www.ino.com\/blog\/2016\/03\/wsj-takes-a-leap-too-far-in-assigning-causation-to-energy-sector-valuations\/","name":"WSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations - 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