Why Use Price to Peak-Earnings?
It isn't difficult to convince investors that stock prices are volatile. Something less known, though, is that corporate profits fluctuate even more. Using a ratio of these two volatile measures is sure to give you misleading signals now and again.
The misleading signal often comes near the end of recession, when earnings plummet. During the 1991 economic recession, for example, the composite earnings of the companies in the S&P 500 fell by 27 percent to about $16 a share. Their stock prices actually rose during that period, as investors looked ahead to better days. The P/E multiple quickly soared to 26 from 15, as earnings fell and prices rose. Since a P/E of 26 is high compared to long-term averages, investors focused on this ratio would have likely missed the beginning of a nearly decade-long rally.
Since stocks are a claim on a very long-term stream of cash flows, using temporarily depressed earnings during a recession is not a very useful way to measure stock valuations. Several years ago, John Hussman created an alternative P/E measure called the "price to peak-earnings ratio" - the current price of the S&P 500 divided by the highest level of earnings achieved to-date. By smoothing out earnings fluctuations (the underlying peak-earnings series looks like a "stairstep" that moves higher each time earnings rise to a new record), the P/E ratio becomes less volatile and more informative.
Even though price to peak earnings is an inherently optimistic ratio – often using an earnings figure from recently sunnier days - history tells us it's a fair assumption. The market's earnings power has always returned to previous levels. (This ratio isn't advisable for individual stocks, though, because many never regain their previous peak earnings).
For more than a century, the price to peak earnings multiple has fluctuated around an average near 14. It was in the single digits in the 1930's and 1940's, as well as 1974 and 1982. It climbed as high as 33 in December 1999. A level of 20 marked valuation extremes that were followed by the price slides of 1929, 1972 and 1987.
- William Hester, CFA