Great Expectations isn’t just the name of a Dickens novel

We’re continually amazed by the plethora of articles in newspapers and financial magazines that trudge over old ground, or what we thought was old ground.

Short example, before we get to the article: why do otherwise wise-seeming publications continue to publish the historical results of mutual funds? Why do they ignore that whole efficient market thing? Why, if the SEC is so confident that past performance is no guarantee of future results that funds are *required* to disclose that, do these magazines feed the general public’s lack of understanding by talking about last quarter’s hot fund or booming stock? Apparently it’s time for us to revisit the issue with an economics professor friend. (Other times, non-financial papers carry articles that seem to be different, except that the message is a general “sometimes go with the old advice/sometimes don’t” — you’ll know afterwards which choice was right.)

In this article by Jonathan Clements, he explains to people why a diversified portfolio of stocks and bonds might be a wiser choice than a portfolio of pure stocks, even though stocks generally return more than bonds. We have to admit that we thought diversification was a long-settled issue and that people learned how to construct portfolios that gave them the desired blend of variance and expected return.

In any event, the more interesting piece of information in the article is a comparison of historical P/E ratios between the early 1980s and today. Clements: “…if stocks reverted to the modest price-earnings multiples and rich dividend yields we saw in the early 1980s, the S&P 500 would tumble 60% or 70% from current levels.” We love this stuff because this type of analysis is one that lends itself to dissecting the omnipresent share price and figuring out what it actually represents. Now, there are those who have argued that P/E ratios reasonably should have increased over the years because earnings are higher quality now, as a result of improvements in reporting, fraud detection, and accounting principles such as revenue recognition. We agree: those issues would make net income more reliable than previously (or at least, strictly speaking, not as likely subject to the same confounding factors).

We think that the more relevant factor, rather than earnings quality, is cash flow multiples. While the problem still remains of matching data exactly, the numbers can be revealing.

More to come, of course.

Leave a Comment