Beyond P/Es – Avoid Over-reliance on Ratios

Thursday, November 19, 2009

1093389_balance_3Ratios provide important information everywhere in our lives, helping us to understand and compare. However, they carry dangers of building false expectations and giving incorrect investment guidance. Here’s where the problem lies:

First, some ratio basics. Anytime one number (numerator) is divided by another (denominator), we have a ratio. Because the ratio is a new number built from a relationship, it can reveal important information. However, it also can disguise what’s happening with the numerator and denominator.

Therefore, the more the ratio is used as a key measure, the more it becomes the point of perception and the underlying numbers lose importance. It can even become a “golden mean,” producing the strong expectation of a “reversion to the mean” whenever the ratio drifts away. Here are two examples:

Gold and silver. The US tried bimetallism in the 1800s, using both gold and silver as currency and setting the ratio between the two. They believed the ratio of gold to silver prices would remain constant at 1:15 through time. Large discoveries (new supply) of silver upset that notion, forcing the US to a gold (only) standard. Nevertheless, even now there are investment recommendations saying that the long-term gold-to-silver ratio is 1:15, so the current ratio of 1:70 makes silver is a great buy.

Oil and natural gas. At times, the ratio of oil to natural gas prices seems to stabilize – 1:6 is an oft-quoted level. These two energy commodities are viewed as rough equivalents that can be substituted for one another, albeit with a time lag. Therefore, the expectation is that a move away from the ratio will be followed by a counter move back. Of course, that hasn’t happened yet this time around, as natural gas discoveries (new supply) have moved the ratio to around 1:20.

You can view how these ratios drive the thinking of many. Search for “gold silver ratio 15” and “oil natural gas ratio 6.” These ratios are the driving force for many investors, rather than the supply/demand factors of each commodity.

So, use ratios with open eyes. They can provide valuable information, but too much reliance on them for investing can be dangerous.

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