The saying “history never repeats itself, but it rhymes,” is often attributed to Mark Twain. I recently saw a blog post from the knowledgeable and interesting financial blogger, Doug Short. In his “Market Valuation, Inflation and Treasury Yields: Clues from the Past,” he offers some interesting charts and data.
The P/E 10 ratio, which shows the Price-Earnings ratio based on recent 10 years of real, per share average earnings, was 26.8, versus the long-term mean of 16.7. Some argue that this measure, much like the Shiller P/E, is no longer valid due to accounting changes which have deflated earnings. However, even after adjustments, it doesn’t inspire a value investor to load up the truck with stocks.
Short cites the level of 30 or greater associated with previous bubbles, such as the Tech Bubble near 2000 and the crash of 1929. Perhaps we have another three points or so, or about 10-15% to run before we are in serious bubble territory. Or perhaps the measure is flawed and doesn’t matter.
He also looks at inflation rates and long-term Treasury yields associated with higher historical P/E 10 ratios. This is logical because lower inflation rates and resultant lower interest rates justify higher P/E ratios and stock valuations due to a lower required rate of return (discount rate) applied to future earnings. You can look up the Gordon Model if you’d like to explore this in depth.
The ominous sign is that we have never (until now) had P/E 10 ratios over 20 and 10 year Treasury yields less than 2.5%. Today’s 10 year Treasury yields 1.75%. The closest we ever came to this was from October 1936 to April 1937, when the 10 year Treasury yield averaged 2.67%. What happened after that? The Dow hit an interim high on March 3, 1937 and fell 49.1% to an interim trough on March 31, 1938.
It’s interesting that the downturn of 1937-38 began almost exactly eight years after the 1929 October crash. The modern day Lehman Brothers and mortgage bubble induced crash occurred on September 15, 2008, close to eight years ago.
Will we avert the rhyme of history thanks to the worldwide, experimental central bank stimulus that has created an artificial recovery, or will Mark Twain prevail?