The WSJ Morning MoneyBeat blog post for Tuesday, March 22, was entitled, “Energy Stocks Are the Most Expensive in S&P 500.”
Are they really?
As I read the WSJ’s post, I decided I really have to use this as an opportunity to help dispel some widely – nay, almost universally held – notions about using P/E ratios to predict stock price movements.
How Not To Use P/E
Almost all investors, in my experience, routinely fall into the trap of misusing the P/E. In fact, I admit I fell into the same bad habit for many years myself. Until a couple of years ago (more on that later).
Don’t get me wrong. It’s not that the ratio can’t be useful. On the contrary, when properly interpreted, P/E can be an indication of sentiment, which is always important for an investor to understand. When P/Es are low (remembering to mentally adjust absolute P/E figures to account for differences in interest rates, inflation, and other market conditions in order to accurately assess whether P/Es are truly “low” or not), sentiment is probably somewhat sour, generally speaking. High P/Es (all things considered) generally mean investors feel willing to “pay up” for earnings, growth, dividends, and/or other perceived benefits of owning stocks. And again, having a feel for what the market’s sentiment is can be helpful (often in a contrarian sort of way).
Beyond the ratio’s use as a rough sentiment gauge, however, I’ve learned several things in the last couple years about using (or misusing) P/E ratios (for individual stocks and for the broad markets), which I’ll summarize as follows: Continue reading "WSJ Takes A Leap Too Far In Assigning Causation To Energy Sector Valuations"