Price/Earnings Ratio (Valuations) Trending Toward Collapse

Posted by John J. Xenakis Feb 12th 2012 at 2:36 pm

Thursday on CNBC, Ron Baron, chairman and CEO of Baron Capital, said that “Because everyone’s afraid to invest, stocks are at the lowest level, the most attractive level, in my lifetime.” He added that he expected the stock market to follow the path of the 1980s, and to rise sharply in the next few years.

S&P 500 Price/Earnings Ratio (P/E1) 1871 to February 2012

Ron Baron, chairman and CEO of Baron Capital, was simply lying. In his lifetime, stocks were the cheapest in 1980, when the S&P 500 Price/Earnings ratio index (“valuations”) was 6.79. Today, according to the Wall Street Journal, the P/E ratio index is at 15.14, higher than the historical average of 13.91.
So Ron Baron, chairman and CEO of Baron Capital, lied on CNBC. We shouldn’t consider this surprising. In the last few years, financial institutions around the world have knowingly created tens of trillions of dollars of toxic synthetic securities and purposely used them to defraud investors. Lloyd Blankfein, CEO of Goldman Sachs, testified before Congress that his criminal fraud was “God’s work.” It would be nice to see him and other financial CEOs in jail continuing their God’s work by manufacturing license plates, but the Obama Justice Department refuses to prosecute or even investigate this fraud (see my recent article “Proposed explanation for repeated Jewish persecution throughout history” for how Boomers and Generation-Xers interacted in creating this fraud).
So, with the Obama Justice Department refusing to prosecute or even investigate anyone, the fraudulent activities continue. People like Baron continue to lie in order to continue to collect fat commissions and award themselves million dollar bonuses. Mainstream media like CNBC and Bloomberg TV invite these people on the air because they return the favor by advertising. Politicians cheer them on in return for huge campaign donations. Even if there are only a few crooks in financial institutions, in the media, and in Washington, they can do an unlimited amount of damage because they can continue to commit criminal fraud at will, without fear of prosecution.
As blogger Lee Adler recently pointed out, commenting on the nonsense from economists on the latest unemployment claims number:

It seems to me that the big surprise is that any economists were surprised, but then, knowing how great the economics profession is at forecasting, I’m really not surprised. The vast majority of economists are either clueless bozos or paid shills, often both.

I like “clueless bozos or paid shills, often both.” I’m going to use that.

Collapsing stock valuations

The clueless bozos and paid shills are talking about the collapse in stock valuations as good news, because it’s time to buy. (It’s ALWAYS time to buy. If valuations are going up, it’s time to buy because they’re going up. If valuations are going down, it’s time to buy because stocks are cheap. Say anything to earn a fat commission.)
However, if you look at the above graph, then you can see that something quite different is going on. Valuations have fallen to the 5-6 range three times in the last century, most recently in 1980. Despite the claims of the bozos and shills, there’s absolutely no reason to believe that it won’t happen again, and you can see from the graph that valuations appear to be headed back to those levels right now. By the Law of Mean Reversion, valuations will probably fall well below 5, since they’ve been so astronomically high since 1995.
One thing about the above graph that’s very interesting is that valuations reach these lows at approximately 32 year intervals, and it looks like that’s going to happen again. This may indicate some kind of fundamental generational financial cycle that I don’t yet understand. At any rate, this should be of interest to the chartists and the numerologists of the world.

Ben Bernanke starts to channel Alan Greenspan

In 2005, I wrote “Ben S. Bernanke: The man without agony,” in which I ridiculed the views of the soon-to-be Fed Chairman because he seemed to have no idea what was going on. For example, he recognized that real estate prices had risen 25% in two years, but he rejected a real estate bubble, because these increases “largely reflect strong economic fundamentals,” such as strong growth in jobs, incomes and the number of new households.
I contrasted Bernanke’s statements to those of outgoing Fed Chairman Alan Greenspan, who was expressing real agony and anxiety over what was going on:

To some extent, those higher [stock and housing] values may be reflecting the increased flexibility and resilience of our economy. But what [investors] perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.

At this point, it’s clear that Greenspan’s agony was right, and Bernanke’s contentment and complacency were wrong. Bernanke’s entire career as professor of economics at Princeton was based on his work that “proved” that the 1930s Great Depression could have been prevented if the Fed had lowered interest rates a little more. But today, after four years of near-zero interest rates and massive liquidity infusion via quantitative easing and fiscal stimulus and bailouts, it’s no understatement to say the Bernanke’s life work has been proven to be completely wrong (the same could be said of other Princeton University economists, including Nobel Prize winners).
I’ve said several times in the past that I respect Ben Bernanke as a man, not because he’s been right (he obviously hasn’t), but because he’s honest, unlike the liars and crooks in Washington, on Wall Street, and on CNBC.
So it’s of interest that Bernanke is now beginning to sound like Greenspan did in 2005. He testified the following to Congress a few days ago:

Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point.

Unfortunately, Bernanke still doesn’t entirely get it, since he’s still clinging to his prior beliefs that bubbles don’t exist and he’s blaming the financial crisis on Congress. But the point he’s making is the same point Greenspan made in 2005: investors are currently underestimating market risk, and history will show that this leads to a sudden fiscal crisis.

What should you do?

I’ve been saying for years that the stock market is going to fall to the Dow 3000 level or lower, and that hasn’t changed.
Trillions of dollars in quantitative easing in the U.S., Europe and China were supposed to generate growth, and that would have happened prior to the 2000s. But today, in a generational crisis era, people have been badly burned, and people and businesses are hoarding cash. In macroeconomic terms, the velocity of money has been crashing.
For almost ten years, I’ve been listening to clueless bozos and paid shills predict “hyperinflation next year,” and it hasn’t happened, and shows no signs of happening. This prediction is made by two categories of shills:

• Gold salesmen, who claim that hyperinflation will drive the price of gold up to astronomical levels. Ten years ago, gold was at around $300 per ounce. Its trend value today is under $500 per ounce, meaning that gold is in a massive bubble, along with the stock market. When the gold bubble bursts, gold prices will crash to below $500. A geopolitical event may cause gold to spike, but it will return to its trend level.
• Stock salesmen, who predict hyperinflation to justify stock purchases, even though valuations have been far above average for over 15 years. The stock market will crash to below Dow 3000.

The signs continue to be, as they have been since 2007, that we’re in a massive worldwide deflationary spiral, meaning that cash will be increasingly valuable.
My advice has been the same for years: preserve your assets. Store cash in your mattress, in your basement, or in FDIC-insured bank accounts. If you must invest, purchase short-term Treasuries. Don’t risk everything for a couple of percentage points interest.