Explosive Earnings Growth
I have made another attempt to improve upon P/E10. The result: a warning about earnings growth in times of high valuations.
New Data
I started from a thinned version of Professor Robert Shiller’s S&P500 data. It is easy to use. It has only the January values.
I constructed moving averages of real earnings, Ex where x=1, 2, 3, 4, 5 and 10. I calculated Ex/E5 and Ex/E10.
I used Professor Shiller’s methodology regarding such averages. That is, I reported an average based on previously collected data only. When I report E5 for 1876, it is the average of real earnings in 1871-1875 (but not 1876). This offset can be an issue when using the thinned data. There is a one-year lag. The offset is never a problem when using Professor Shiller’s complete data set. The adjustment is only a single month.
Data Analysis
I looked at plots of earnings ratios Ex/E5 and Ex/E10. A higher ratio means a faster rate of earnings growth.
WATCH OUT FOR THE PEAKS.
A low ratio implies good news for investors. A high ratio signals impending danger.
Real Earnings History
The years 1929 and 1965-1966 were the most difficult for retirement portfolios. The highest valuations in terms of by P/E10 occurred in 1929, 1965-1966 and 2000.
The real earnings in January 1929 were $15.52. The year before, they were $12.42. Real earnings grew to $17.27 in January 1930. They fell to $11.21 in January 1931.
The real earnings in January 1965 were $27.93. They were $31.26 in January 1966. Back in January 1964, they were $25.01. Real earnings grew to $31.81 in January 1967. They fell to $29.86 in January 1968.
The real earnings in January 2000 were $55.17. The year before, they were $43.80. Real earnings fell to $52.52 in January 2001. The dropped to $26.45 in January 2002.
Historically, the stock market has been most dangerous at or just before a peak in real earnings.
False Positives
Earnings ratios peaked twice in the 1950s. Those were great times to retire. What was different? P/E10 was low.
Conclusion
Rapid earnings growth sends an ambiguous signal.
When P/E10 is high, explosive earnings growth signals danger.
If P/E10 is depressed, rapid earnings growth can be a good sign.
Have fun.
John Walter Russell October 17, 2006
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