Price to book
While the market’s view of any company may be captured in the P/E ratio, the return on equity is what drives shareholders. Another important ratio is the price-to-book (P/B) ratio, as it takes into account all the factors (external and internal) influencing the price, giving an idea of the company’s health to investors. In fact, the P/B ratio is a sort of an extension of ROE and also is correlated strongly to P/E ratio.
Generally, the P/E ratio relationship to earnings is countertrend, as earnings mostly peak before prices; thus, earnings being reported quarterly is a problem. This is solved by the P/B ratio, which has different ratios for different market sectors and business types. Hence, an indicator for market sentiment is created that indicates whether people are ready to invest more in stocks in the immediate future.
Study shows that relationship of the P/B ratio is similar to earnings:
- An expanding P/B ratio is bullish.
- A contracting P/B ratio is bearish.
Our P/B data begins March 31, 1988 and is available only for the Dow Jones Industrial Average, so the test will be limited and stick to the simpler methodology — that is, SP500_EarningSimple (MkLen,IntLen). While the P/B ratio data is for the Dow, it is applicable enough to monthly moves in the S&P 500 to serve as a proof of concept. The test runs through Nov. 30, 2011. During this period, the S&P 500 made 822.77 points. We used a six-month moving average for both S&P500 and the P/B ratio.
The model went short on June 30, 2008, but did not reverse and cover up until June 2010. The market rallied almost 30% before we exited this short position. Some of the logic we used in our more complex earnings model would have helped this system, but unfortunately the limited data set doesn’t allow the degrees of freedom needed for a more complex approach to be valid.
History points the way
Understanding and using history to build a long-term market model is a ripe area of research. Perception affects prices. An expanding P/B ratio means people are willing to pay a high multiple for assets. Further, it means people perceive economic improvements — similar to how corporate bond spreads narrowing can precede market rallies.
Alas, these models are not necessarily viable for trading. The holding periods are too long, masking the risks and uncertainties of short-term fluctuations when leverage is employed. However, as long-term business or personal financial planning tools, they can provide invaluable guidance. In addition, combined with the right timing logic, they may offer filtering benefits for shorter-term systems.
Murray A. Ruggiero Jr. is the author of “Cybernetic Trading Strategies” (Wiley). E-mail him at email@example.com.