Relative Strength Can Signal Valuation (P/E) Expansion
Nov 28, 2010
in Relative Strength
A typical buyside analyst looks at the world in terms of business fundamentals, earnings estimates, quality of management, competitive position, competitive advantage, return on invested capital, P/E multiples and so forth.
You will often hear analysts talk about P/E’s being low relative to growth rates or low vs 10-year bond yields or low vs a group of comparable companies or the overall market etc.
Is the price/earnings (P/E) multiple a good indicator for future performance? One interpretation of this fundamental valuation measure is rather than thinking in terms of the current valuation vs ‘fair value’ --- is simply to observe whether the valuation is expanding or contracting and decide if you believe this will continue.
If a P/E has just gone from 14x to 12x, its cheaper – but is that bullish? How do we know its not headed lower? We should probably test this and see if it works and then create some guidelines for portfolio strategy based on this. Wouldn’t that make sense rather than just blindly believing that a lower multiple is bullish?
Relative strength can actually be thought of as fundamental analysis if you wish to think about it like that. It would not be unusual for a fundamental analyst to say during a rally “the P/E multiple is still too low at 12x next years earnings” -- even though it’s up from a low of 9x and you bought the stock at 10x. But this is not any different than watching relative strength and buying at the same price and looking for further valuation expansion.
Good relative strength analysis captures when a market segment is experiencing valuation expansion. A low P/E is not actually bullish unless its low and then expands higher. This is the crucial aspect – not the absolute level of valuation.
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