Ask Colin

It is reported (end June start of July 2003) that Wall Street Experts have a bullish consensus, which is bearish, but PE ratios are high. How can that be?

The idea behind bullish consensus being bearish is very similar to the idea of overbought on a momentum oscillator. As the market rallies, it starts with a few bullish people buying. This move builds on itself as others become bullish when they see prices rising. Their buying then pushes the price up further. Gradually more and more people become buyers on the "fear of missing out" syndrome. As they all buy, they become committed to further rises, so there develops a consensus that prices will rise. However, as the consensus builds, all the buying is done and the move is bound to end - either go into a correction or change to a down trend. Hence a bullish consensus is bearish.

High PE ratios (leaving aside the argument about historical versus prospective ratios, because both are seen to be high at present) indicate that the market is over valued and so should fall. So, at present a bullish consensus and a high market PE ratio are both indicating the market should fall.

Another issue here is a possible timing mismatch. PE ratios are not a precise timing indicator - the market can be out of line with PE ratios for a long time. Whereas bullish consensus usually indicates a more imminent change in market direction. So, PE ratios are a long term indicator, but bullish consensus is a short term indicator. It is quite possible logically for them to be opposed at times - A bearish consensus with high PE ratios may just mean that a sell-off is overdone or we have an oversold condition that is indicating the likelihood of a rally.

The other thing that is difficult to gauge is the rather elastic relationship between PE ratios and inflation/interest rates. In 1974 we saw single digit PE ratios at the bottom, but inflation was relatively high. I remember 15 to 18% yields on debentures. Since interest rates are much lower this time, I would not expect that PE ratios will get as low as 1974 and yet still imply an oversold market. In my Newsletter No 30 I suggested a way to relate PE ratios to bond yields, but it is only a loose relationship and it depends on the assessment of risk as to what premium you build in over the risk free rate.