Relative Strength Can Signal Valuation (P/E) Expansion

Nov 28, 2010 in Relative Strength

A typical buyside analyst looks at the world in terms of business fundamentals, earnings estimates, quality of management, competitive position, competitive advantage, return on invested capital, P/E multiples and so forth.  

You will often hear analysts talk about P/E’s being low relative to growth rates or low vs 10-year bond yields or low vs a group of comparable companies or the overall market etc.

Is the price/earnings (P/E) multiple a good indicator for future performance?   One interpretation of this fundamental valuation measure is rather than thinking in terms of the current valuation vs ‘fair value’ --- is simply to observe whether the valuation is expanding or contracting and decide if you believe this will continue.

If a P/E has just gone from 14x to 12x, its cheaper – but is that bullish?  How do we know its not headed lower?  We should probably test this and see if it works and then create some guidelines for portfolio strategy based on this.   Wouldn’t that make sense rather than just blindly believing that a lower multiple is bullish?

Relative strength can actually be thought of as fundamental analysis if you wish to think about it like that.   It would not be unusual for a fundamental analyst to say during a rally “the P/E multiple is still too low at 12x next years earnings” -- even though it’s up from a low of 9x and you bought the stock at 10x.  But this is not any different than watching relative strength and buying at the same price and looking for further valuation expansion.

Good relative strength analysis captures when a market segment is experiencing valuation expansion.  A low P/E is not actually bullish unless its low and then expands higher.  This is the crucial aspect – not the absolute level of valuation. 

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Comments (2) -

Nov 29, 2010 09:15 #

Another important statistic is what extreme P/Es mean for the future on different time scales.  From the data I've looked at, a low P/E means something when you look at the resulting returns 1-2 decades later, but very little for performance over the next month.  For intermediate/swing and short term traders, P/E isn't as useful a statistic.

Erik United States

Nov 29, 2010 12:26 #

Right,  I am not saying this is not what you meant ----  I guess where I should have gone with the blog post was that there are just many market segments beyond Large Cap U.S. Equities to look at --- and the the S&P 500 P/E contracting or expanding is just one market of many...  For example, the valuation of bonds rallied big over the summer.  The valuation of Indian equities (EPI, INP) expanded sharply higher from May to early November while U.S. bank stocks (KBE) and home construction stocks (ITB) and Natural Gas commodities (GAZ) all have done nothing but go down.

Again, I know you were not saying the opposite.  I just wanted to point out that different market segments expand and contract their valuations at different times.  While the P/E of the U.S. market might do one thing -- this dramatically understates the rotation opportunities in the market each year.

Chris United States

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