Economic price to earnings

What Is Economic Price to Earnings?

Economic Price to Earnings refers to the examination of the price-to-earnings (P/E) ratio within a broader macroeconomic context, analyzing how aggregate market valuations relate to economic conditions, business cycles, and overall earnings trends, rather than focusing solely on individual company performance. It is a concept rooted in valuation metrics but extends into macroeconomic analysis, seeking to understand if the equity market as a whole is overvalued, undervalued, or fairly valued given the prevailing economic environment. This perspective often involves looking at aggregate P/E ratios, such as those for major stock market indices, and their historical relationship to key economic indicators like Gross Domestic Product (GDP) growth, inflation, and interest rates.

History and Origin

While the basic price-to-earnings ratio has been a fundamental tool for individual stock valuation for decades, the concept of "Economic Price to Earnings" gained prominence with the recognition that market-wide P/E ratios can signal broader economic conditions and potential future returns. A significant development in this area was the work of economist Robert Shiller, particularly his development of the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, also known as the Shiller P/E. This ratio, which uses the average of the past 10 years of inflation-adjusted earnings, aims to smooth out the cyclical fluctuations in corporate earnings over economic cycles to provide a more stable and economically relevant measure of market valuation. Shiller's work, notably in his book "Irrational Exuberance," published in March 2000, highlighted how historically high market P/E ratios, adjusted for economic cycles, preceded periods of lower stock market returns²², ²³. His analysis provided a framework for interpreting market valuations from a macroeconomic perspective, suggesting that aggregate P/E levels are influenced by and can reflect broad economic sentiment and fundamentals²¹.

Key Takeaways

• Economic Price to Earnings analyzes aggregate market valuations, such as broad stock indices, in relation to wider macroeconomic factors.
• It helps assess whether the overall equity market is overvalued or undervalued by considering economic conditions rather than just individual company performance.
• The Cyclically Adjusted Price-to-Earnings (CAPE) ratio is a prominent example, smoothing earnings over business cycles to provide a more stable valuation metric.
• High Economic Price to Earnings values can signal potential lower future long-term stock market returns, while low values might suggest higher future returns.
• This approach aids investors in understanding systemic risks and opportunities within the market landscape.

Formula and Calculation

The most prominent example of an "Economic Price to Earnings" metric is the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio. While a standard P/E ratio uses a company's current share price divided by its earnings per share (EPS) over the past 12 months, the CAPE ratio modifies the earnings component to account for economic cycles.

The formula for the CAPE ratio is:

$\text{CAPE Ratio} = \frac{\text{Real Stock Price}}{\text{Ten-Year Average Real Earnings Per Share}}$

Where:

• Real Stock Price: The current share price of a market index (e.g., S&P 500) adjusted for inflation.
• Ten-Year Average Real Earnings Per Share: The average of the past ten years' earnings per share for the market index, also adjusted for inflation. This smoothing helps to remove the effects of short-term fluctuations in earnings due to economic cycles like recession or boom periods.

Interpreting the Economic Price to Earnings

Interpreting the Economic Price to Earnings, especially through metrics like the CAPE ratio, involves understanding historical patterns and broader economic contexts. A high Economic Price to Earnings ratio, relative to its historical average, suggests that the overall equity market may be overvalued. This implies that investors are paying a premium for each dollar of real earnings, potentially forecasting lower long-term returns from stocks¹⁹, ²⁰. Conversely, a low Economic Price to Earnings ratio might indicate that the market is undervalued, suggesting a potential for higher future long-term returns.

This interpretation is crucial for strategic asset allocation and long-term investment planning. For instance, if the Economic Price to Earnings is significantly above its historical mean, it might indicate increased systemic risk within the equity market. The Federal Reserve Board often monitors broad valuation pressures, including the P/E ratio of the overall market, as part of its financial stability report to identify potential vulnerabilities in the financial system¹⁶, ¹⁷, ¹⁸.

Hypothetical Example

Consider an investor, Sarah, who is evaluating the overall U.S. stock market using the concept of Economic Price to Earnings. She looks at the S&P 500 index.

1. Current Market Data: The S&P 500 index is currently at 5,000 points.
2. Historical Earnings Data: Sarah gathers the inflation-adjusted earnings per share (EPS) for the S&P 500 over the past ten years. Let's assume these real EPS figures average out to $150.
3. Calculation: Sarah calculates the CAPE ratio (a form of Economic Price to Earnings):
   $\text{CAPE Ratio} = \frac{5,000}{150} = 33.33$
4. Historical Comparison: Sarah then compares this 33.33 ratio to the historical average CAPE ratio for the S&P 500, which has typically been around 16–20.
5. Interpretation: Her calculated CAPE ratio of 33.33 is significantly higher than the historical average. This suggests to Sarah that, from an economic perspective, the broad equity market might be richly valued, implying potentially lower average annual returns over the next decade compared to historical norms. This contrasts with looking at a single year's P/E, which might be distorted by temporary high or low earnings during specific economic cycles.

Practical Applications

The concept of Economic Price to Earnings is a powerful tool in several practical applications, particularly for long-term investors and policymakers.

• Long-Term Investment Strategy: Investors can use aggregate P/E metrics, such as the CAPE ratio, to inform their asset allocation decisions. During periods of high Economic Price to Earnings, some investors might reduce their exposure to equities, favoring other asset classes like bonds or real estate, expecting lower future stock market returns. Conversely, low Economic Price to Earnings environments could signal a favorable time to increase equity market exposure.
• Macroeconomic Analysis: Economists and financial institutions, like the Federal Reserve Board, utilize these broader valuation metrics as economic indicators to assess the stability and health of the financial system. ¹⁴, ¹⁵Elevated market-wide P/E ratios can be a sign of valuation pressures and potential systemic risk, influencing discussions around monetary policy and fiscal policy.
• Identifying Market Bubbles: Historically, extreme spikes in the Economic Price to Earnings have coincided with speculative bubbles. For example, the dot-com bubble in the late 1990s saw the S&P 500's P/E ratio reach exceptionally high levels, ¹³which were later cited by Robert Shiller as evidence of "irrational exuberance". ¹²Understanding these patterns helps in identifying periods of potential market exuberance that could lead to significant corrections.
• Academic Research: The relationship between Economic Price to Earnings and future market returns is a frequent subject of academic study, seeking to refine valuation models and understand market efficiency. Data provided by institutions like the Federal Reserve Economic Data (FRED) from the St. Louis Fed are crucial for such analyses, offering extensive historical economic data series for researchers.
  ¹⁰, ¹¹

Limitations and Criticisms

While providing valuable insights, the Economic Price to Earnings concept, particularly the CAPE ratio, faces several limitations and criticisms:

• Timeliness and Reactiveness: The use of a 10-year average for earnings means that the Economic Price to Earnings is a lagging indicator. It reflects past performance and may not quickly adapt to sudden shifts in the economic landscape or corporate profitability. ⁹Critics argue that modern economies and corporate structures have changed, rendering historical averages less relevant for predicting future performance.
  ⁸* Accounting Standard Changes: Over a 10-year period, accounting standards and corporate reporting practices can evolve, making direct comparisons of historical earnings per share challenging. Differences in how companies calculate and report earnings, including adjustments for non-recurring items, can affect the accuracy of the underlying data.
  ⁶, ⁷* Structural Economic Shifts: Long-term changes in interest rates, inflation regimes, corporate taxation, and the industry composition of the equity market can influence what constitutes a "normal" or "fair" Economic Price to Earnings. For instance, persistently low interest rates might justify higher P/E ratios than historically observed, as investors demand lower returns from fixed income and thus accept lower earnings yields from equities.
• Not a Market Timing Tool: The Economic Price to Earnings is best used for long-term strategic insights rather than precise market timing. A high CAPE ratio does not guarantee an immediate market downturn, nor does a low one promise an immediate rebound. ⁴, ⁵Markets can remain "irrationally exuberant" or "irrationally pessimistic" for extended periods.
  ³* Ignoring Growth Prospects: A high Economic Price to Earnings might be justified if the market anticipates strong future earnings growth across the economy. The ratio itself doesn't explicitly account for changes in long-term growth expectations or the emergence of disruptive technologies that could fundamentally alter earnings trajectories.
  ²

Economic Price to Earnings vs. Price-to-Earnings (P/E) Ratio

The distinction between "Economic Price to Earnings" and the conventional "Price-to-Earnings (P/E) Ratio" lies primarily in their scope and purpose. The standard Price-to-Earnings (P/E) Ratio is a micro-level valuation metric typically applied to an individual company's share price relative to its earnings per share. It helps investors assess whether a specific stock is undervalued or overvalued compared to its peers or its own historical performance, often using recent trailing or forward earnings.
¹
In contrast, "Economic Price to Earnings" broadens this analysis to a macro level, focusing on the collective valuation of the entire equity market or a significant portion of it. It seeks to understand the market's relationship with fundamental economic conditions, business cycles, and long-term earnings trends for the economy as a whole. While the standard P/E provides a snapshot of a company's current valuation, Economic Price to Earnings offers a longer-term, more systemic perspective on market health and potential future returns, often employing methodologies like the Cyclically Adjusted Price-to-Earnings (CAPE) ratio to smooth out short-term economic fluctuations and provide a more robust economic signal.

FAQs

What is the primary difference between Economic Price to Earnings and a company's P/E ratio?

The primary difference is scope. A company's Price-to-Earnings (P/E) Ratio assesses an individual company's valuation, while Economic Price to Earnings analyzes the valuation of the overall equity market in the context of broader economic conditions and business cycles.

Why is a 10-year average used in the Cyclically Adjusted Price-to-Earnings (CAPE) ratio?

A 10-year average for real earnings per share is used in the CAPE ratio to smooth out the impact of short-term economic fluctuations, such as booms and recessions. This provides a more stable and representative measure of underlying corporate profitability over a full economic cycle, making the valuation less susceptible to temporary spikes or dips in earnings.

Can Economic Price to Earnings predict market crashes?

While a high Economic Price to Earnings can indicate an overvalued equity market and suggest a higher risk of lower future returns or potential corrections, it is not a precise market timing tool. Markets can remain elevated for extended periods even when the Economic Price to Earnings suggests overvaluation, as factors like investor sentiment and monetary policy also play a significant role.

How do interest rates influence Economic Price to Earnings?

Interest rates can significantly influence Economic Price to Earnings. When interest rates are low, the present value of future earnings tends to be higher, which can support higher market valuations and thus higher Economic Price to Earnings. Conversely, rising interest rates can make fixed-income investments more attractive, potentially leading to lower market P/E ratios as investors demand higher returns from equities.

What other economic factors are considered when analyzing Economic Price to Earnings?

Beyond just interest rates and business cycles, analysts consider factors such as inflation, Gross Domestic Product (GDP) growth, corporate profit margins, aggregate demand, and the overall health of the labor market. These macroeconomic variables collectively influence corporate earnings and investor sentiment, impacting the overall market's valuation as reflected in the Economic Price to Earnings.