Price-to-Earnings

The Price-to-Earnings ratio (P/E) is used to help value a company or index relative to its per-share earnings. For example, if an index has a P/E ratio of 14-times, investors are paying $14 for every $1 in earnings,  A high P/E ratio could mean that a company's stock is over-valued or else that investors are expecting high growth rates in the future. 

The Dow Jones Industrial Average (DJIA) in its present form is beginning its 101^st year.  It is actually124 years old (May 1896), however, accurate records only began in 1920. According to Value Line Publishing, between 1950 and 2000 the average P/E was 12.4.  Whenever this number went up to near 20 it was due to falling earnings.  Shortly after that the economy slid into recession.

This century the average P/E has soared.  Between late 1999 and 2005, the average P/E ratio jumped to 14.4.  Since then the trend has been rising.  We estimate the historical average today is running at just under 16-times, or roughly 25% below today’s numbers. Todays P/E is warning us that the stock markets are overvalued.

Assuming a P/E of 12.4, 14.4, 16 and 19.6 means investors believe corporate profits will double every 5.8, 5, 4.5 and 3.7 years, respectively.  The 3.7 years is impossible to meet.  It would require massive wage increases that are then leveraged, followed by a major spending spree like none other before. Inflation would most likely takeoff, pushing interest rates up in the process.  This would cause the U.S. economy to contract.  Plus, every politician would be busy raising taxes to cover the higher interest expense on their debt.  It would drag down most of the world economy. 

It is easy to see why the Toronto stock market (TSX) has done little for the past four years.  It was, and still is, because of politics. While America has stressed business, jobs and lower taxes, Ottawa has been telling the world do not invest in Canada. One example is Bill C-69, which guarantees no infrastructure can be built for at least the next 10 years.  Ottawa has been successful in destroying one of Canada’s biggest industries and taxpayer, the energy sector. 

Ottawa has wasted the past four years listening only to the environmentalists and turning a deaf ear to all businesses.   It is business that creates the money that finances most environmental organizations, no matter which side of the debate.  It should be noted that it is also business that finances the research and innovation needed to make the world a better place. Ottawa has been 100% lucky because America has its lowest unemployment rate on record.  Canada’s numbers are not bad, but we must wonder what they would be if America was in a recession since they are our biggest trading partner. 

We are into the longest bull market in history.  How much longer can it last? One week, a month, a year – nobody knows.  But, outstanding debt for all levels of government and the average consumer is a ticking time bomb.  Canada’s consumer debt is $1.77 per $1 of income, one cent off its record high.  The U.S. Debt Clock states that their total debt is equal to just under $70,000 per person - a record that grows every second. 

As the debt grows cash becomes king.  For the stock markets we can see a potential 30% downside based on its current P/E.  Earnings in the next recession will be falling so the market could fall further than the 30%.  Until we see a noticeable change of attitude out of Ottawa, our recession will be worse than in the U.S. 

Fortunately, most of the companies we invest in are cash rich and will weather the coming storm.  For the next two years we predict it will be dividends and money market investments that will be the main source of returns; the same as the past three out of four years.   

Based on the dividend yields on our purchase prices it will mean we should easily be near the top for all investment returns.

Note of Interest: During July the Bloomberg Baltic Exchange Dy Index, an index that measures the price of shipping raw materials across 23 global marine shipping routes, traded around 2,440.  On Friday January third, the index fell 16.6%, which is one of the biggest one day drops on record.  On the eight there was another 6.9% decline, followed by a further drop to 773.  This is a warning that world trading has fallen off a cliff.  If this trend continues a recession is almost imminent. Let’s hope it had more to do with the Christmas season rather than Trumps destructive tariffs, and it reverses upon signing of a new trade agreement between the US and China.