Investors Column – Recession … and P/E


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February 22, 2022 by Scott Crosby - Views: 29

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Investors Column – Recession … and P/E

Are we in a recession?

S257-1.jpgThe S&P 500 peaked at 4818 in late December – early January.  As this is written, it is at 4470.  That is a decline of 7 1/4 percent.

Most people consider a recession to be when the market drops ten percent or more.  Ten percent would put the S&P below 4336.  So by that light, we are not in a recession.  

And yet, if your portfolio is down, it sure feels like a recession.  Some of the hot Tech stocks have experienced a drop of more than ten percent.  

Adobe (ADBE) is down 26 percent from its high in November.  That is definitely in "Ouch" territory, if you own some.

In contrast, Microsoft (MSFT) is down only 12.6 percent, and Apple is down less than 6 percent.  Why the difference?

Take a look at their P/E ratio – the stock’s price divided by the company’s earnings per share.  Traditionally, a P/E of about 17 has been considered the norm, for most types of companies.  Why?  Because at 17, a well-run company could be expected to have a typical return on its investment from its level of sales.  

A lower P/E indicates either the stock is undervalued (and may be worth buying), or that the company is not doing so well (and not worth buying).  A higher P/E indicates the stock is overvalued (time to sell), or doing unusually well (hold on to your stock).

Would you risk investing $1,000 if your expected earnings was only $1 per year?  No.  If you made $100?  Maybe.  If you made $500?  Sounds like a great deal.

In the August column, it was noted that Chipotle’s P/E was at 90.56, and the share price in August hovered around 1900.  Now the P/E is down to 59.56.  Chipotle’s share price is about 1495 – it has fallen more than 21 percent.  If you had invested $1,000, you would have only $790 now.  Ouch.

In August, Microsoft traded around $290.  It climbed all the way to $359 until the current recession pulled it back … to $300.  Adobe has fallen from the 640s in August, to the low 500s.  Its P/E is still high, at 51.25.  Microsoft’s P/E, in contrast, is comparatively low, at 32.58.  Apple traded in the 150 range in August; it is now above 170, and its P/E is at 28.66.  Seeing a gain through a recession is a nice way to weather the storm.

Apple’s P/E still seems relatively high.  But a lot of people are buying stocks who “traditionally” were not typical investors.  P/E values are being kept higher by investors’ enthusiasm rather than by paying attention to what a P/E means, and what it implies about a company’s future.  That enthusiasm was first labelled in 1998 by Alan Greenspan, then the Chairman of the Federal Reserve.  He called it “irrational exuberance” – an appropriate term for people ignorant of how a P/E is calculated, and of what it means.

To be sure, Apple and Microsoft tend to be very profitable.  Perhaps a higher P/E should be considered “normal” for them.  How do they compare to their peers?  Knowing the answer to that question is important to you as an investor.

Let’s look at another industry:  automobiles.  General Motors’ P/E is 7.66 – and GM has not been too profitable for a number of years.  Ford’s P/E is 25.19.  Ford’s stock has doubled in the last year, as a result of their announcements touting their forthcoming electric cars.  Is the higher P/E appropriate, or just more irrational exuberance?  

Compare Ford’s  P/E to its peers:  Toyota’s P/E is 10.15; that sounds about right.  

Then there is Tesla’s P/E – at an astronomical 188.43.  One pundit said it could go much higher; another pundit said Tesla’s stock price could drop to a fifth of its current value.  Were Tesla’s stock price to drop by 80%, its P/E would still be in the 30s – still much higher than the P/E of other auto manufacturers.

Which pundit is right?

Building cars is building cars; there is no magic.  Tesla is dealing with public complaints, safety issues, and recalls.

Another indicator is “market capitalization” – the stock price multiplied by the number of shares outstanding.  

GM’s market cap is 74.5 billion.  Ford’s is 72.9 billion.  Toyota’s is 273.8 billion.  All three make cars, trucks, and more, in countries around the world.  Tesla, which makes a limited variety of car models, has a market cap of … 927.3 billion.  

What are the Tesla investors counting on?  Irrational exuberance, indeed.

The current recession is far from over; it could easily last another year.  And the President still seems intent on leaving his mark on history, no matter how bad the impact.

If you own a stock with a high P/E, why do you expect to see an increase in its price to come your way in 2022?■  

 

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