Behavioral P/E Ratio

Since investment is highly dependent on one’s frame of mind, and on healthy scepticism, I try to avoid reading any investment writer regularly.  When I succumb, as I sometimes do, and especially if s/he is a good and prolific writer,  I find myself unconsciously adapting his or her weltanschauung, and getting lost because I would not know all the ins and outs.

One exception is Jeremy Grantham, of GMO; I read whatever he writes, and the more he writes, the more I enjoy reading him.

In December 2011,  the GMO Quarterly Letter, entitled “The Shortest Quarterly Letter Ever”,  he refers to work he did on the P/E ratio as follows:

“Well, 15 years ago, Ben Inker and I designed a model to explain (not predict) the ebbs and flows of the P/E ratio.  It had a surprisingly high explanatory power.  We found that everything that made investors feel comfortable worked. That is to say, it was a behavioral model.  Fundamentals like growth rates did not work.  The two (out of three) most important drivers were profit margins and inflation. ”

Grantham goes on to surmise that the reason why the S&P500 is not higher today, in spite of high profit margins and tame inflation, is because of the “cloud of negatives”, as he calls them, pressing down on the market.

Quite apart from the light the “behavioral P/E” throws on the current situation, this passage struck me for the way Grantham gets sentiment to play in what’s usually considered to be a ratio based solely on financial parameters.

Sentiment always comes in to play via Price, the “P” in my SEP framework.

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