current price earnings ratios of growth and value indices

good analysis. Thank you.

The short answer is I suspect there has been 'style drift'. Value and growth are getting rather confused (as you point out).

So telecommunications, media and some technology stocks, and some pharma cos are 'value' whereas some resource stocks make have become 'growth'. Banks tend to figure prominently in 'value' indices, since they habitually trade at lower PEs than the market.

Value in an academic context is almost always price to book (or rather book to market value in the econometric tests). Studies of other measures don't show the same 'value effect'.

B, I think you know this, but you could look at that by comparing the characteristics of DFA's mutual funds with analogous ETFs whose portfolios are based on published indices. Ostensibly that was their motivation for founding DFA -- mutual funds that were "true to the research". I have some materials from them showing comparisons to indices, but unfortunately they're stamped all over "advisor use only". From publicly available info you can see that there are differences in number of securities, market cap, and book-to-market metrics for some portfolios. Whether these differences will persistently result in performance differences is open to debate, especially when factoring in the costs one might pay to access these funds, vs. ETFs (including tax costs, if that's relevant).

On your general point - I thought of this when you posted a similar paper recently...I've always though that the value premium, at least in part, can be explained as the advantage you get when you avoid bubble stocks. A value investor systematically avoids them. If widescale mispricings (and resulting crashes) are periodic events in equities markets, both on a macro scale and with smaller batches or sectors of securities, the value investor benefits from systematically avoiding these events - or at least, not buying those securities during the peaks in valuation. And to a lesser extent, that investor avoids the more subtle bubble-buying, on the individual-security level -- such as that experienced by someone owning a Nasdaq 100 tracking fund (which adds stocks only after they've run up far enough to be one of the 100 largest by market cap...perhaps systematically "buying high"?).

To the extent this thesis holds water, it would make sense that there would be an ebb and flow to the value premium. When you're in a bubble, you benefit from overweighting value, when the market is more fairly valued, you don't. Of course the catch is identifying these periods using something other than hindsight.

-Tad

It's interesting that P/E is used to measure value...

....but it is not used to measure value... How then does one measure the premium?

-Will

Remember that these indicators suggested a year ago that growth "should" outperform value. Didn't happen.

Lots of evidence indicates that such attempts to time markets are futile. The only things true about the market are true only on the average in the long run. On the average in the long run, value outperforms growth and probably small outperforms large. This year? Nobody can say.

The way of wisdom is to choose an asset allocation that tilts toward value and small and is appropriate for your age, wealth, and risk tolerance. You can do this with Vanguard or even better with DFA. Then sit on your hands, resisting the temptation to trade. In a few decades, you will probably be rich. As Warren Buffet said, "Activity is the enemy of investing."

One small coda, which I hesitate to bring up because it may open the gates of temptation. There is some evidence of slight mean reversion in the market. That is, on the average in the long run, periods of above-trend performance tend to be followed by periods of underperformance. The effect is small and is overwhelmed by noise at time periods less than (perhaps) a decade or so. But in practical terms, the books by Malkiel (1980) and Schiller (2000) performed similar comparisons of stock prices with economic, historical, and value measures. Malkiel found that stocks were shockingly undervalued

-- he was two years early, but the great 18-year bull market started in

1982. Schiller was lucky (and it was just luck) to hit the top almost exactly. Despite the "Dow hits record" hype, the S&P 500 is still 5% below its March 2000 high and the NASDAQ is straining to get back to half its March 2000 value -- 7 years later. Keep repeating "only on the average in the long run" and remember that in this game 7 years is not the long run. A convincing call every 20 years may be about all we can look for.

David

Value investment is defined as the style of choosing stocks that are trading below their intrinsic value. On average, econometric tests show that the best indicator of value of a portfolio is a high average book-to-market price ratio (low P/B). Other indicators, such as a low price/earnings ratio, have a weaker relationship with value. This article:

provides a good survey of the empiricalliterature in this area. That said, an individual stock with a P/B of 5 and a P/E of 30 (for instance) may have more value than a stock with a P/B of just 1 and a P/E of just 10. It all depends on factors such as the future earnings prospects of a company. An example: a stock with a P/E of 30, but with stable earnings growth rates, which can be more or less accurately projected at a rate of 20 percent a year during the next 10-yr period has more value than a stock with a P/E of just 10 but with very risky earnings prospects, which average zero growth during during the next

10-yr period (just do the exercise using

This article from the New York Times confirms my earlier comments.

the Bubble, With Small-Cap StocksBy MARK HULBERT Published: March 18, 2007

"This picture of a highly bifurcated stock market is painted by data from Ford Equity Research of San Diego, which tracks around 4,500 publicly traded companies in the United States. Among companies that have been publicly traded for at least seven years, the firm reports that 55 percent have higher price-to-earnings ratios today than they did in March 2000. The bulk of these pricier issues, however, are in the smaller-cap sectors. Among the very largest companies, the average P/E ratio is now just a third of what it was seven years ago."

The academic literature is all about price to book (or rather the inverse book to market value).

It sounds like this is one of those cases where 'value' and 'growth' have become marketing terms. It's no longer transparent to the outside investor what is a 'value' and a 'growth' stock.

Many of these companies have prodigious free cash flow relative to their capitalisation. My own observation is that large cap 'growth' stocks are as cheap as they have ever been relative to the market (Barton Biggs says he cannot find evidence they were ever cheaper). However as you highlight, a typical 'growth' stock like GE, WalMart or Pfizer, is now rated in PE terms as if it were a value stock.

The managements of these companies have a lot of scope to add value simply by financial engineering: buying back stock, selling operations to private equity, spinning out subsidiaries. Even if organic growth remains sluggish.

Biggs also points out that these stocks are a good hedge against global inflation, given the international diversification of their operations.

======================================= MODERATOR'S COMMENT: Posters to this thread should relate comments to general financial planning.

wrote

Little clarification:

That last sentence is a little loaded, it seems to me. I was hoping the article as a whole did not seem to suggest that large companies are currently a "great buy." Unfortunately, it does tend to do so. So one sees

"According to Standard & Poor's, for example, the P/E ratio of the S& P 500 currently stands at 17, based on trailing

12-month operating earnings. The comparable ratio at the end of March 2000 was 31.1, almost double the current level."

So an S&P 500 index fund is a real bargain now, if P/E is one's main criterion?

Not necessarily.

Shiller's data shows the average P/E to be 14.6 for the period from 1871-2003. Since WWII, it's still averaged about

2. I would not say, explicitly or implicitly, that the S&P 500 is a good buy right now. It's not bad, maybe, but relative to historical valuations, it's not impressive. go back to

1988 or even 1995, when its P/E was close to 11 and 14, respectively, and then I might start suggesting it's a good buy.

The information in this article is not correct. As of February 28, the average trailing P/E of the broad market was 16.24 (and given the declines in the last 3 weeks, it is almost certain that it is lower than 16 as of right now):

. In any case, the average P/E is not the most relevant indicator of how much a certain category of stocks (small or large caps) are over(under)valued, but the average P/B (see article at the DFA library cited above). The average P/B of large caps is still significantly larger than the P/B of small caps.