Broken Indicators: The Forward PE And The PEG

The forward PE ratio is broken. It has the rona. Stop using it.

And the PEG ratio is worse than broken, it never worked in the first place.

As an investment research professional, I spend much of my time working on analytical tools and frameworks to help understand the risk/return outlook across financial markets.

Aside from building indicators it also involves the regular discarding or at least down-weighting of various factors and indicators through the cycle and through time as their efficacy ebbs and flows and the strength/validity of their signal comes and goes.

As you might guess when I see broken, misleading, or ineffective indicators getting attention it kind of bothers me. Normally I wouldn't say anything, but I think in these extraordinary times you almost have a public duty to participate in the discussion and set things right.

So join me if you will on a journey through the guts of these broken indicators.

1. The Faulty Forward PE: The forward PE ratio takes price divided by the consensus estimate of earnings over the next 12 months (so it is sometimes called the next 12 months or NTM PE). The typical behavior of this indicator is that it will rise during a downside shock to earnings; giving the appearance of an expensive market. So it should be no surprise that with the global economic shutdown earnings expectations have collapsed and thus we are left with the impression that the market is expensive...

2. In Search of a Reliable Valuation Anchor: Enter the PE10. The PE10 takes price divided by the average of trailing (historical) earnings of the last 10 years. The reason for doing this is it provides a more stable anchor for making judgments about the level of valuations. That's why it is sometimes referred to as the cyclically adjusted or normalized earnings PE ratio.  

The chart below shows a standardized (historical z-score) view of the PE10 and the forward PE. Let's focus on 2009: shortly after the market bottom the forward PE ratio shot up to "expensive" levels. Meanwhile, the PE10 (with the benefit of hindsight) remained at "cheap" levels.

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