What is the right Price-to-Earnings (P/E) ratio?

As I prepare to go on a well-deserved vacation, I title my last article in January again as a question rather than as a statement. The main reason for this is that I really do not know, and as always, am curious about others’ opinions. I have devoted the last months of research to the topic of monetary economics and currency issues.

As I studied the area of cryptocurrencies, the preponderant role that supply/demand dynamics play in the short-term pricing of assets became increasingly clear to me. Since the recovery in prices of risk assets took hold following the collapse into 2009, there has been a ‘bull market in bubble calling’. The scars of the global financial crisis (GFC) left many pundits prone to try to call the next bubble.

There has also been much talk over the last year of the return of ‘animal spirits’. Confidence (and in some cases, apparently overconfidence) in the outlook for prices of risk assets has indeed taken hold. Over the last few weeks there have been comments, including my own, on the ‘bull market in everything’, which I in turn have dubbed rather the fall in the US dollar against most everything else.

Investor sentiment readings are indeed ‘off the charts’, and signs of complacency are all around. There have also been, particularly in recent weeks in connection with the typical turn of year shifts in asset allocation, great flows of money into stocks and other risk assets. Still, I wonder how ‘overweighted equities’ everybody really is.

Following years of ‘de-equitization’, my bet is that this trend still has long-term legs. This, of course, does not mean that stocks can go straight up. Corrections should be anticipated and are a healthy trait in markets. Indeed, one of my own greatest concerns regarding the durability of the bull market is the fact that it has not been sufficiently enough punctuated by bouts of profit-taking. A meltup in global stocks has been one of my most dreaded scenarios.

But, in the long run, pricing in markets must be dictated by fundamentals, and there is an adequate level of valuation for everything. In the case of stocks, one of the most important and accepted valuation yardsticks is the P/E ratio. What the specific P/E for a particular company is at any given point in time, in my view, is determined by sentiment and supply/demand dynamics. Thus, in the short run, technical analysis (of which I know little to nothing) does play a much more important role than I historically have acknowledged.

As I recently wrote, “supply and demand dynamics determine if the ‘right’ price-to-earnings (P/E) ratio of a stock is 16 or 18x.” In a given environment, the ‘appropriate’ P/E for a particular stock may be 16x, just as the exact same company at some other point in time may seem fairly priced at 18x. My theory is, increasingly, that supply/demand dynamics play a varying role in different asset classes.

Generally and everything else being equal, according to this new hypothesis of mine, the safer and more reliable the cash flow streams from an asset, the lower the role that supply/demand dynamics play in its short-term pricing. Thus, while a consumer staples company with a long and stable history may see its stock relatively little affected by demand for it, in the case of cryptocurrencies, it is almost all about how much supply and demand there is for the ‘asset’.

Between these relative extremes are tech-reliant stocks such as Microsoft (MSFT) closer to the stable side than Netflix (NFLX) or Tesla (TSLA), approaching the cryptocurrency side of the spectrum. Thus, according to this theory, the ‘appropriate’ P/E of a stock may well be extremely high for a surprisingly long period of time due to growing demand for its stock, regardless of fundamentals. Of course, I still would not advocate investing on this premise, as some would call it no more than betting on the ‘greater fool theory’.

Finally, a couple of examples to more clearly illustrate these points

The more orthodox your fundamental thinking about stocks, the more you are likely to insist a corporation’s stock should have the following characteristics. Shares of companies should be a direct claim on the company’s cash flows after covering debt obligations. The company should have only one class of stock, with one share equaling one vote.

These are two characteristics the stock of Swiss National Bank, on which I wrote my last article, lacks. Thus, the P/E of the ‘company’ is currently well less than 1x. The Swiss central bank, which is obviously not to be run in the interest of its shareholders, caps both the voting rights and dividend it may pay. But is this not also the case with Snap Inc. (SNAP)?

The company, on which I have also written, has publicly traded stock that has no votes. Many tech-related stocks pay no dividend (or plans to ever pay one). And finally, there are cryptocurrencies. What are participants ‘investing’ in? It is all about the price appreciation potential from selling to somebody else willing to pay a higher price at a later point in time. It is all but everything about supply and demand.

Indep. GLOBAL portfolio mgr; former PM at $LM's Batterymarch,Fidelity,Putnam & RCM (now Allianz Global Investors).Crusader for #finlit & vs #shortermism. RT ≠ E