Smithers: P/Es and Fed Model Are "Nonsense"

Andrew Smithers, of London-based Smithers & Co., has published another free lecture, this one entitled "Behavioural Thoughts on Equity Valuation."  In it, Smithers takes aim at two of his betes-noire: the use of standard P/Es and bond-yield ratios to determine whether the market is cheap or expensive.  Such metrics are "nonsense," Smithers says, and have no predictive value.  He then produces the charts to prove it.

As previously discussed, the trouble with standard P/Es (based on Price/Current Earnings or Price/Forward Earnings) is that they don't take into account the business cycle: When profit margins are fat, as they are today, P/Es look artificially low, and when margins are thin, they look artificially high.  The trouble with bond-yield ratios, Smithers says, is threefold:

• They have no theoretical justification.
• They don't work.
• Their apparent predictive capability is the result of data mining.

The bogusness of these valuation metrics, of course, doesn't stop dozens of Wall Street strategists (and Fed governors and financial journalists) from using them--a fact that Smithers attributes to Wall Street's need to always conclude that stocks are cheap.

As in other reports, Smithers argues that the only two valuation metrics that are valid are cyclically adjusted P/Es (CAPE), which take into account the business cycle, and Tobin's Q, which is a measure of price to replacement cost.  These metrics, Smithers says, meet the five key tests of validity:

• The "fundamental" is measurable and relatively stable, and the price ratio to this fundamental is mean-reverting.
• The measure must make economic sense.
• The measure must tell you something (but not too much) about future returns.
• The measure must have been predictive in the past.
• If there is more than one measure, they must generally agree.

At the end of the lecture, Smithers uses CAPE and Q to show that the U.S. market is significantly overvalued, but notes that this tells us little about what it will do in the next year or two.  He observes that intelligent fund managers, whose jobs depend on not missing big bull moves, would be dumb to bet on an intermediate-term decline, even when it has a 70% chance of occurring.  Why?  "Because a 30% chance of ruining your business or career is too high."

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