What causes price/earnings ratios to shift so dramatically?

The major determining factor is interest rates. When interest rates rise, price/earnings ratios tend to fall. When interest rates decline, price/earnings ratios tend to rise.
There are two reasons for the profound effect of interest rates on price/earnings ratios. The first has to do with how money managers behave. The stock market is one place where a money manager can invest funds, but there are other alternatives, and the relative attractiveness of those alternatives can affect the amount of money that goes into or out of stocks.
For some investors the stock market competes for funds with the bond market. Stocks carry risk, but long-term bonds carry less risk. A20- or 30-year bond can have some awfully wild swings before the payoff (maturity) date, but some money managers look at long-term bonds as an alternative to stocks because at least they know these bonds will have a certain maturity value at a certain fixed point in time, at which time their original investment will be intact. Stocks, obviously, carry no such guarantee.
When other money managers are deciding whether to commit more or less capital to the stock market, what they’re really looking at as an alternative is the “no-risk” alternative—cash.
By “cash” we mean money market funds or short-term treasury securities, where a dollar invested today will be worth a dollar tomorrow, unequivocally and with no other potential outcome. This is the riskless alternative to the stock market, and the interest rate a money manager can earn on this riskless alternative is perhaps the major variable that determines the price/earnings multiple placed on a given level of earnings.
Suppose, for example, you are managing a pension fund for a large company. Your job is to make sure that when employees retire they will receive their pension benefits. Your company has set aside a certain amount of money for this purpose and instructed you to invest it in such a way that when the benefits have to be paid, at some point in the future, there is enough money to pay them. Ateam of actuarial accountants has prepared a very nice booklet, complete with actuarial tables, that sits on your desk. And what this booklet tells you, basically, is that if you can earn 8 percent per year on the money that’s been left for you to manage, there will be enough money to pay the retirees and everyone will be happy.
As you sit there and survey the investment scene, you see that long-term U.S. government bonds are yielding 6 percent. That will do you no good because you need to earn 8 percent or the retirees will be calling you up for loans so they can maintain their standard of living 20 years from now. The yield on money market funds, at 4.75 percent, is even less.
To earn the required 8 percent, therefore, you will have to take some risk—and that means you’ll have to invest in the stock market. Although stocks do not come with guaranteed returns, they do offer upside growth potential. And since there’s no other way to get the 8 percent you need, you take the plunge into the market.
Across the street there is another money manager in charge of another company pension fund. His job is just like yours, except his company has a lousy union and the pension benefits for its retirees are going to be a lot less than yours. According to the actuarial tables, the money manager across the street needs to earn only 6.5 percent on his investments to fund the retirement plan.
So, you’re both in the same boat—at least for now. You need to earn 8 percent and the money manager across the street needs to earn 6.5 percent, but neither one of you can get what you want in bonds or money market funds, so you’re both buying stocks.
Now, let’s suppose interest rates start to rise. The yield on the 30-year government bonds jumps to 7 percent. This is still not good enough for you because you need 8 percent to fund the pension plan. But the money manager across the street now faces an interesting situation. He needs 6.5 percent to fund his plan; he can get 7 percent in U.S. government bonds. In order to do his job, all he has to do is buy bonds and go shoot a round of golf. He will also have a lot less stress. And he must now ask the question: If I can get the 7 percent I need in government bonds, why should I be taking risks in stocks? That is a very good question, and the answer will likely be that this money manager will begin moving at least a portion of the funds he has invested out of stocks and into bonds. And if the interest on “cash” investments, like money funds and short-term treasury bills, also reaches 7 percent, he will likely move a lot more money out of stocks. In other words, as interest rates on less risky investments rise, a certain amount of money will leave the stock market to lock in that return. At 7 percent, a certain number of investors will determine that they do not need to take the risk the stock market entails. At 8 percent, a new round of money managers will make the same decision. Each uptick in interest rates will suck money out of the market because the lesser-risk return meets some investor’s goal, which is one reason why rising interest rates almost always put downward pressure on the stock market.
The profound effect of interest rate movements on stock prices is the major reason Wall Street is so obsessed with Alan Greenspan and the Federal Reserve, even to the point where CNBC analyzes the size of Greenspan’s briefcase as a potential clue as to whether the Federal Reserve is about to shift its interest rate policy.
There is another reason why rising interest rates usually mean lower stock prices. It’s a bit more complicated but its worth knowing, and it explains a big part of the mystery of the wildly gyrating price/earnings ratios touched on earlier.
This concept is called “discounted present value,” and what it boils down to is this: If you know what a company will earn over the next 10 years, what is that future earnings stream worth today?
Again, what the market is willing to pay today for those future earnings is the price/earnings ratio.
Let’s use this example:
Suppose Totter’s Rollerblades Inc. (TRI) is estimated to earn a grand total of $50 per share over the next 10 years. This means if you buy one share of TRI today, you are buying a piece of that future earnings stream. What is that future earnings stream worth right now? Put another way, what amount would you have to invest today to have $50 ten years from now?
Answer: It depends on the level of interest rates. The higher the level of interest rates, the less you must invest today to get that $50 ten years from now. In other words, when interest rates are high, the present valueof that $50 will be less than it would be when interest rates are lower. High interest rates will result in the present value of that $50 ten years from now being lower, while low interest rates will result in present value being higher.
For example, if you want to have $50 ten years from now and interest rates are 10 percent, you only have to invest around $19
today. But if interest rates are at 5 percent, you will have to invest $31 today to get that $50 ten years from now.
Think about that for a moment. Ten percent interest rates make the present value of $50 ten years from now worth $19. Five percent rates make the present value $31. In other words, given the earnings projections for Totter’s Rollerblades Inc., the present value of those earnings can be worth anywhere from $19 to $31, depending on the level of interest rates. And if you think of a stock price in terms of present value, you can see how interest rates can have a profound effect on what Wall street will be willing to pay today for a projected future earnings stream. Same company, same earnings projections—the only difference is what those earnings are worth right now in any given interest rate environment.
That, in simplified terms, is how most stocks trade. For the most part they’re at the mercy of earnings forecasts that are constantly changing and may or may not be on the mark, and they’re at the mercy of interest rate movements that cause professional money managers to move into and out of stocks in general and that will alter the value of your investments as rates fluctuate, even if earn- ings estimates are accurate.