Up Is Down

Alcyoneus,

I got a "Page Not Found" message when I tried to link to the Infoworld article. Could you be a little helpful and just summarize the article? I really do not want to read an entire article just to understand your point.

John Dewey: http://www.infoworld.com/article/05/08/23/35OPr...>

The DOL maintains a private market for domestic jobs, using taxpayer money.

Alcyoneus: "The government uses public tax money to recruit foreign labor --- forcing domestic workers to pay their competition. That's an unfree market."

Sorry, but I really don't know what you are referring to. How does the U.S. government recruit foreign labor? Can you be a little more specific?

Hi John Dewey,

I shop there often. Although I have a reasonable suspicion of Chinese goods, I'm not for protectionist tariffs. Each individual consumer should decide what products meet their desires. Because many (or at least some) Chinese goods are manufactured using the forced labor of political prisoners, I refuse to but Chinese goods. Contrary to the views expressed often at Cafe Hayek, individual consumers making such decisions engage the full meaning of free markets.

I would be against government monies to aid Walmart at the expense of other businesses, and I would oppose efforts by other businesses to enact laws that penalize Walmart. I just want the same for labor. The government uses public tax money to recruit foreign labor --- forcing domestic workers to pay their competition. That's an unfree market. Why is that controversial to free-market types? I dunno.

Given the political preferences of the editors, why would one expect anything other than an advocate for socialism to be writing on economic issues for the New York Times?

Ok fine, you can judge the relative "value" of stocks using PE if you wish, although doing so across industries and different periods of time is mostly meaningless.

Nor is P/E particularly useful for companies with negative earnings. And are we talking about "scrubbed" P/E or the crap that most companies put out which is rife with non-economic accounting nonsense? Even scrubbed, P/E is a poor measure of anything unless it's a stable, mature, cash cow company. But even then, as Snguyan said, it can't be compared across industries and time. Not very useful.

Alcyoneus,

How is it "force of law" when consumers are allowed to buy whatever goods they wish to buy? What government intervention is involved when Walmart imports goods from China? Allowing consumers and businesses to buy from whomever they wish is pure and simple freedom. Slapping tariffs and restrictions on one group of suppliers takes away that freedom.

Krugman is a buffoon. Except when he argues for anarchism, Boudreaux isn't, but he still denies there is a problem.

The government uses the force of law to advantage foreign labor, i.e. foreign businesses. (Workers are just small businesses, remember?) Free market economists cover their eyes and call that a "free market."

The free market economists differ little from Krugman: both advocate government intervention in favor of privileged business interests. Their only disagreement is over who gets the privileges and who doesn't.

Buffoonery on one side, and dishonesty on the other. Yuck.

I quit. Yes, Spencer, you're correct...predicting P/E direction is highly useful. For if one can accurately forecast the direction of P/E movement, one has a 90% chance of increasing their wealth providing that they're rational.

Know anyone who can do this? Perhaps it's as easy as selling as the company that you may own shares in, announces earnings growth, or, buying shares when a company disapoints. I'll keep my eye on this one as I drink heavily and maybe I'll see your econometric model show something that'll make me money.

Spencer,

Let me summarize what I think you are saying:

If a stock is priced at $10 at a point in time with $1 earnings, it has a PE ratio of 10. Then later (say the next year) the earnings go up to $1.20 but the stock rises to $24, the PE is now 20.

The stock price has risen by 140%. The earnings rose by 20%, and the PE rose by 100%. Are you saying that 20/(20+100) = 16.6% of the change is due to earnings, and 100/(20+100)= 83.33% of the change is due to PE?

I never stated that 2 things that have the same price have the same value.

In your original statement you claimed that changes in the S&P (a price) are due to changes in earnings(22%) and changes in PE(a ratio that is comprised of earnings)78%. By its definition, using PE includes any changes in earnings.

In your amended statement you exchanged "present value of expected future earnings" for PE (not equivalent by the way) This phrase is actually closer to the equivalent of the price of a stock, although in fact the correct formula is the current stock price =the present value of future dividends.

You now seem to be talking about PE as a measure of value between stocks. Ok fine, you can judge the relative "value" of stocks using PE if you wish, although doing so across industries and different periods of time is mostly meaningless . However, this is not particularly germane to your initial statement.

You have essentially changed what you said 3 times, as well as come to the bizarre conclusion that I have said price and value are the same. I am not going to argue this any further.

Here however is a thought experiment for what I am trying to point out about your initial statement. If every company in the S&P took a 10% earnings haircut today, but all investors expectations of the future did not change one iota.(PE changes but no one buys or sells) would the price of the S&P change?

You are saying just because the happen to have the same price they have they have the same value and nothing could be further from the truth.

No I did not want to say price I wanted to say value. The PE is the expression of the value of a stock, not the price.

If you have two stocks priced 100 and one has $5 eps and a Pe of 20 and one has a $10 eps and a pe of 10 they do not have the same value just because they are both prices at 100.

The one with a PE of 20 is twice as expensive as the one with a pe of 10.

price and value are two completely different things and the PE is a measure of the value.

The S&P 500 is simply a price derived from its 500 constituents weighted by market cap.(In fact theoretically, if the price were to stay the same and floats changed you would in fact have a change in the S&P that has nothing to do with future expectations, but that is not the point I was making)

This is what you first wrote verbatim:

"from the bottom in 1949 to the peak in 2000

only 22% of the change in the S&P 500 was due to changes in earnings while 78% was due to


changes in PE"

As written it is nonsensical. You can't say changes in price are caused 78% by a ration and 22% by part of that very same ratio.

Instead of PE as you allude in the second bit you wrote, what you probably meant to say was price. PE and Price are not interchangeable.

Furthermore in terms of stock valuation, it is the Price of the stock, not the PE ratio, that is the present value of future DIVIDENDS not earnings.

snyquyen -- that is pure stupidity.

I'll express it this way. 22 Of the rise in the market was due to present earnings. 78% was due to change in the present value of expected future earnings.

This has absolutely nothing to do with float.

don't you have any idea what you are talking about. do you have any idea about stock valuation?

from the bottom in 1949 to the peak in 2000

only 22% of the change in the S&P 500 was due to changes in earnings while 78% was due to


changes in PE

This is fundamentally a nonsensical statement. 100% of the change in the S&P is at all times due to the change in price and on a lesser degree the change in float of the components. This only really makes sense if you mean changes in PE due to changes in price versus changes in earnings.

sorry -- second para should be 1949 to 1961 not 1940.

How about this joe--

from the bottom in 1949 to the peak in 2000


only 22% of the change in the S&P 500 was due to changes in earnings while 78% was due to


changes in PE.

From 1940 to 1961 Pe changes accounted for some 91% of the rise in the S&P 500.

From 1961 to 1974 EPS rose 145.8% while the market fell 6.5% so pe changes accounted for over 100% of the market changes.

From 1974 to 2000 earnings accounted for

27% of the market rise & valuation changes


accounted for 73% of the market rise.

From the peak in 2000 until 2005 the market fell 15% while eps was up 31%.

Sorry, i have not updated the most recent data.

lowjoe -- I'm just reporting facts.

On average since WW II in a stock market

bear market the s&p 500 PE falls 26% while


EPS rises 11%.

On average, in the first year of a new bull market the S&P 500 PE rises 33% while earnings fall 4%.

I know what I am talking about. The data

completely support the comments I have made.

Moreover, I have good econometric work that expains most of the changes in the market PE

in terms of interest rates and inflation.

try a PE equation that works since WW II

with an R squared of 87 and a standard


error of about 1.

""Krugman is a hack."

Enough said." - M.Hodak

Yes, but he's a hack people listen to. And that is the dangerous part.

"Krugman is a hack."

Enough said.

Krugman says he's an economist but has never proven to be anything but a cheerleader for socialism in America. His flawed thinking is extremely damaging considering the huge audience he commands writing for the NYT and reinforcement he gives to the liberal college notions. The main incorrect notion is that if one person makes money, someone else loses it and it's usually rich guy getting and and poor guy losing. It's of course, utter nonsense and....exactly what Karl Marx was thinking so many years ago.

I agree with MeThinks. Krugman needs therapy.

Its the ancient boom and bust cycle myth of economics. The cycle is not a natural feature of a free market economy, its caused by inflation. The government prints too much money or extends too much credit, we have inflation and unbalanced economic growth. The government tightens up the money and credit supply, we have a collapse. Its as simple as that. The Federal Reserve was founded in part to solve the problem of the business cycle, but if its all true, then why did the Great Depression come afterwards?

My observation is that however bad inflation is, deflation is even more disasterous.

Krugman is a hack. Somebody needs to hand him some anti-depressants and a clue.

The cause of the recent market tumble is the expansion of credit spreads (a phenomenon not seen for over a decade) and a new reluctance to extend generous leverage terms by brokers. Recently, stock prices have benefited from the private equity boom. As credit tightens, fewer deals will be done, decreasing demand for stocks. One observation I made over the past few weeks is that companies identified as potential buy-outs tank on days when credit spreads expand and rise on days when the credit spreads tighten or, at least, don't expand further. Brokerage firms have demanded more margin than before, forcing funds to sell assets to meet margin calls. This has a snowball effect as selling puts further downward pressure on stock prices, triggering more margin calls. The self-perpetuating cycle stops when brokerage clients have been delevered enough.

Some have been calling this a "repricing of risk". That's probably true. As the world has become wealthier, the demand for investment vehicles has increased as well. In search of yield, investors have driven up prices of debt instruments such as high yield debt so much that a friend lamented (two weeks before spreads exploded) that junk bonds were being floated with yields similar to "A" rated debt.

What finally caused the reversal in the stock market? I'm not certain. However, CDOS and CLOs, for which no liquid market exists, were being marked to model because the lack of a liquid market made risk assessment difficult. The model assumed a certain risk and the hope was that this shot in the dark hit the target. Everything was fine as long as the world didn't change much. When mortgage defaults began to increase as floating rate mortgages began to reset, the world changed. Suddenly, nobody was willing to take the same risk for the historically paltry payoff, credit spreads exploded and heretofore uncalculated risk suddenly came under intense scrutiny.

Another thing to keep in mind - if the firm has both liquid assets (like stocks) and illiquid assets (like CDOs), the firm will sell the liquid assets to meet the margin calls. That's but one way the credit market - not global economic growth - drives down the stock market.

Next thing Krugman will be telling us is that economic growth leads to inflation and that productivity gains lead to unemployment. He needs to be checked for dementia.

When is that great unraveling going to occur anyway?

Soon, very soon...God willing. And you can say you heard it from me first.

So most major US indices rise for nearly 4 years straight, then drop back to where they were in recent months, and people are proclaiming that stocks are dropping in price? QQQQ is currently where it was in late June, DIA is currently where it was in late April. Both are still around 20% above last year's levels. Why are we even discussing the dropping of stock prices?

Fortunately, I don't read PK enough to remember if he was vocal about stock prices rising. But in the past he has complained about high unemployment levels when they were actually lower than historical averages so it might be his continual attempt to make things look worse than they really are. When is that great unraveling going to occur anyway?

Anything can be residual because purchasers of shares can be looking at anything. If, as you claim, price is THE residual, then surely the P/E is also a residual because price is a component variable of the P/E.

While lots of smart buyers and sellers look at P/E as a driver when making their transaction decisions, many others do not -- and they maybe smart as well. Some look at return on equity, some look at revenue growth, some at price to book...there are many things that any one investor may look at.

Again, P/E is the amount (or price in dollars) that people in the marketplace are willing to pay for one dollar's worth of earnings and it reflects investor sentiment -- whether that sentiment is due to some sort of speculation or whether it is due to the expected returns (yields or earnings streams) on competing asset classes.

So, bottom line is that predicting sentiment or speculation (in terms of the direction of movement of P/E) is not always as useful as you might think...earnings can continue to grow proportionaly more rapidly than the price increases and P/E will contract (and be reduced) just as it possible for earnings to slump while prices fall at a pace proportionaly slower causing the P/E to actually rise. Does it generally happen this way, though? No, it does not! And it is because the delta of the earnings is pretty much the most sensitive driver of market sentiment (aka P/E).

If the most dangerous time to be in the market is, as you claim, just after earnings growth turns positive, and the smart money knows this, too, then why do you suppose that good earnings news (projected or actual growth of earnings) boosts the price of stocks and earnings disappointments lowers stock prices?





Speaking for myself, I generally view earnings growth favorably while viewing a decline in earnings less so. Here's a question I have for you: if earnings continue to show positive growth without letting up, will it be even more dangerous to be in the market?

joe -- the PE is not the residual, the price is the residual. Yes, what you are saying can happen. But if you look at the historic data it is very, very rare. That is why the probability is very high, but not perfect. The last couple of years of a falling PE and a rising market are very, very unusual.

If I asked you to predict the value of the market next year you would predict two things. One, what are earnings. Two, the value to place on those earnings, or the PE.

The PE is an expression of the current value of the future stream on income and is a function of interest rate and inflation.

I will be glad to show you all kinds of econometric models and stock market studies that demonstrate this.

One of the examples that falls out of this is that one of the most dangerous times to be in the market is right after EPS growth turns positive. 1987 is a perfect example of this.

Ammonium-- the foreign markets are falling more because they are essentially the high Beta portion of the current world stock market. It is just standard present value analysis that changes in the discount factor have a bigger impact -- both ways --on high Beta stocks.

Saying that being able to predict the direction of P/E ratios would give one a 90% probability in predicting the direction of the market is too simplistic.

As you should know, the P/E ratio is a funtion of earnings and measures the relationship of how much (in $s) the market is willing to spend for a dollar's worth of earnings. Therefore, the market's earnings can grow and the P/E can remain the same, and the market WILL go up. Earnings can also increase and the P/E ratio decrease and the market STILL go up provided that the earnings increase had a stronger effect than did the market's waning willingness to purchase a dollar's worth of those hypothetical earnings increases.

I will not argue, though, that your explanation of interest rates and inflation expectations drive P/E -- I, too, believe that debt instruments compete with equity for investment vehicles in which to park wealth.

If stock prices are falling because of the booming global economy, then why are all of foreign funds fallen as much or more than my American funds in the past several days? Or do booms especially hurt the countries where the economy is booming?

While the positive correlation between earnings or economic growth and stock prices is well known, what is little known is that the correlation between the change in earnings and the change in stock prices is essentially zero.

Bear markets almost always occur when the economy and earnings growth is strong because that is when inflation and interest rates increases tend to force down the stock market PE -- an expression of the present value of a future stream of earnings.

Even if you have perfect knowledge of what earnings will be next year it is of no help in determining where the market will be.

But if you can be right on the direction of the PE change you have a 90% probability of being right on the direction of the market.

So before you accuse someone of doing poor analysis it might pay you to actually look at the historic record.

I have to side with Paul Krugman on this one: everyone knows that global booms surpress economic activity and therefore the earnings of publicly traded companies.

This all stems from global imbalances that cannot be sustained. What the markets need is a major correction -- a pause in prosperity; a period of pain -- so that after the correction we can be prosperous. You do understand, right?