Earnings and PE ratios in the Great Depression

Stock prices have risen about 40% from the low a few months ago. The main reason appears to be that people think the recession will end soon and that stocks are simply pretty cheap. Though I disagree about the recession ending, I would have to agree that stock look pretty cheap with the emphasis on the look.

For example the 30 stocks in the Dow Jones Industrial average have an average PE ratio of about 13. It is about the same whether you use trailing earning or forward analyst estimates for next year. Well 13 is indeed pretty cheap compared to the long term average of about 15.

But looks can be deceiving. The question is what the earnings will be in the future. Corporate profits as percent of GDP were recently at an extreme value. The long term trend for real earnings (as compiled by Robert Shiller) puts the S&P 500 earnings at about 50. That would be the trend value not the value one might expect in a very deep recession. Typically earnings fall to about half the trend during deep recessions. So earnings for the S&P 500 might be more like 30 over the next few years. With the S&P 500 at 900 that would put the PE ratio at about 30. Not so cheap looking anymore.

Let's look at the data for the Depression years 1928-1936 as an example.



This plot shows the aggregate earnings (black), stocks prices (blue) and the (trailing) PE ratio in red. The data is from Robert Shiller's data-sets. The stock prices have been divided by 17.

In late 1929, the bubble popped and stock prices fell as market participants realized that corporate earnings would fall and that stocks were overvalued. The PE ratio fell quickly from about 20 in 1929 to about 13 by the beginning of 1930. People naturally expected a quick economic recovery and decided that stocks were cheap. After-all, a PE of 13 (just like today) is pretty enticing. So began the rally of 1930. The PE ratio jumped up to about 18 before the rally fell apart. The market then fell steadily with occasional rallies until the bottom in late 1932. The amazing thing is that the PE ratios never strayed far from 17 during the rest of the bear market except for right at the end when it fell quickly to bottom at 10. The blue line is price over 17 so the fact that the blue line traces the black line demonstrates this. It is just that earnings fell steadily until they fell to about 7 from the peak at 26, a 73% decline. The story of the great bear market was really one of corporate earnings not valuation.

The moral of the story of course is that a PE ratio is pretty meaningless by itself. What matters is where earnings will be in the future. The best guide to that is simply mean reversion. Corporate profits tend to revert to about 6% of GDP. They recently peaked at almost twice that. If they bottom at half this average that would be a 75% fall just like in the Depression. If that happens we might expect the S&P to fall to at least a PE of 15. The S&P 500 earnings peaked about about 85 so a 75% decline would be 21 and a 15 PE would bring the index to a horrifying 315 a 65% decline from here.

Of course this might be overly pessimistic or it might not. But the point is that stocks will follow future earnings and that those will likely go down from here. Stocks are not nearly as cheap as they look.