Did He really say that? (Pt III)

Tuesday, 3 March 2009 by bbbeard.

“What you’re now seeing is a profit and earnings ratios get to the point that buying stocks is a good thing if you have a long-term perspective on it.”

Do you think He knows what “P/E ratio” stands for? I’ve listened to the video a couple of times and, even allowing for off-the-cuffiness of the exchange, it’s not clear to me that he does.

UPDATE (10 March 09):

Delta Foxtrot says I’m being cryptic. So here are some deeper observations that flesh out this particular complaint:

Well, the superficial observation is that at first and second listening Obama apparently refers to the “profit and earning ratios” of publicly traded companies. The problem with that is that the meaning of “P/E ratio” is “price / earnings ratio”, not “profit / earnings ratio”. To a market already badly shaken in its faith in our 44th President, to confuse “profit” with “price” is a faux pas that would only send the market down further. He should consider bringing a TelePrompTer before he says anything at all about the markets.

But this is a quibble. Perhaps he meant to say, “corporate profit [COMMA] and [IMPLICTLY: price / ] earnings ratios”. However, this reflects a deeper confusion about the meaning of the P/E ratio.

The “price” in “P/E ratio” means the per-share stock price times the number of shares outstanding. What determines the price? Conventionally, a company is ‘worth’ its net present value (NPV). The NPV is the total present value of all anticipated future net profit streams, discounted using the usual formula for time value of money. In quant form, the present value is discounted from the future value by a factor that depends geometrically on time, that is, PV(t) = FV(t)*exp(-k*t), where k is an interest rate.

Now, for a company working in a ’static’ (slow-growth) industry, like, say, a paper company, next year’s earnings are likely similar to this year’s earnings. So if you compute the NPV of a static income stream, the NPV is just (this year’s earnings) divided by (the discount interest rate k), e.g. if k=8%, the P/E should be about 12.5. So ceteris paribus, the companies in a given sector should all be priced with similar P/E ratios. This tells an analyst whether a stock is overpriced or underpriced. Small changes in a company’s prospects can shift the actual P/E up or down. If a company is in a high-growth sector (like computers 10 years ago), the P/E ratio can be very high, because the anticipated growth of the company’s revenue can exceed the discount rate(!). So many tech stocks were trading at P/E’s over 100 (until the bubble burst)….

So, here’s the rub — if a company, or an entire sector, has P/E’s lower than historical averages, it means that investors believe that profit streams are likely on a downward trend. It doesn’t necessarily mean that the company is a great buy. And when an entire market has low P/E, it means that the assessment is that the economy is in a long-term downward spiral. It doesn’t mean the market is a good buy at the low P/E. It just means that investors have taken into account all the currently available information and have concluded that the net present value of each and every stock that has a low P/E, is low.

So, when Mr. Obama gets up in front of international film crew and says, “Hey! Buy now! P/E ratios are really low!” that’s well, kind of ass-backwards, not to mention a little scary. The P/E ratios are low because he has convinced the market he is out to ruin the market system, or at least, he really doesn’t care enough about capital markets to learn the first thing about them.

More thoughts about the P/E ratio: stocks in general behave a bit like “martingales” (link to a book here), that is, a “martingale” is a random variable that changes erratically as time passes, in a way that the expectation of a future value is equal to its current value. Stocks are a bit different than pure martingales because of the time value of money (”TVM”), but the martingale concept can still be applied with some adjustment. What that means, in short, is that there really isn’t anything like a time when “stocks are a great buy” or when “stocks are overpriced”. Unless you know something about the future that the market doesn’t know. For example, you might “know” that Obama is about to repudiate all the economy-hostile measures he has promoted (like the trillion-dollar deficit). In that case, the market assessment of values (tied to the projection of the future profit stream) for nearly all stocks would increase. And before the repudiation, stocks would be a great buy. Or you might “know” that Obama is going to announce the forced merger of GM, Ford, and Chrysler into a single government-run “American Motor Company” — prior to the announcement would be a good time to sell your stocks (or buy “puts”).

Nonetheless, one of the ways in which stocks do not simply behave like TVM martingales is that their price includes an implicit risk deflator. That is, the projection for the expected value of GM stock might be that profits will start to grow year-on-year at say, 5%, leading to a per-share price of, say, $100. But there might be considerable uncertainty about the projection — some analysts might predict a 3% yearly growth, others, 7%. The effect of the uncertainty will be to depress the stock price. Even though the expected value of the net present value of the future profit stream is $100 per share, the uncertainty might drive the stock price to, say, $90 per share. The difference is called a “risk premium” by analysts. If the uncertainty grows, the stock price declines even further.

Now, it is quite apparent that a huge risk premium is attached to stock prices right now, in addition to the penalty exacted for the impacts of massive deficits, the impending cap-and-trade tax, and massive tax increases on the productive class. Not all of this is Obama’s fault, of course — we live in interesting times! But inasmuch as the market incorporates all available information, including, e.g. North Korea’s pronouncement that shooting down their missile will spark a wider conflict, Obama’s incompetence in foreign relations also exacts a toll on the markets.

Now, the thing is, as time passes, projected risk diminishes — a year from now we will know what GM’s profit in 2009 will have been. So, a year from now, we will have a better, albeit still incomplete, idea of how Obama’s policies will play out. By March 2010, we will know if he got his trillion-dollar deficit passed, we will know if foreign investors abandoned Treasury securities or stuck with us, we will have a better idea how the November 2010 elections will turn out. Thing is — even if the news is bad, removing the uncertainty can drive the market up. The catch is, as time passes, uncertainty can also increase. If Obama’s actions in the domestic and foreign policy arenas become increasingly erratic, it may keep the markets depressed even as the economy recovers.

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