Both sides of the picture

When financial and economic ratios are out of whack from their long-term averages, it is not unreasonable to expect an eventual correction and a return to more normal times.

However, while ratios serve as useful measures of the extremes, the trap that it is all too easy to fall into is to overestimate their predictive qualities by failing to properly appreciate from which side the correction will come. A few examples:

- House price to income ratio: This yardstick was severely stretched for many years. Many analysts focussed on the idea that a steady rise in incomes would allow for house prices to remain elevated. Others used it as a signal that house prices were too high and expected a correction - they were proven right, but only after many years of being wrong.

- Dividend yield/Bond yield: I've read quite a bit of analysis about how the dividend yield is attractive when compared to the bond yield, making stocks a good long term buy. But how will the ratio correct? If the world bond market is in a bubble, then bond yields could spike up very quickly when the bubble bursts. Also, the FT is reporting that 'Companies cut their dividends at the highest rate on record at the end of last year.'

- Price to earnings ratio: When the P/E ratio is low relative to the long-term average, this can be used as a preliminary buy signal for value investors. However, what does it mean for the future that you may be to buy a company's past earnings at a good price? Who knows. A good example is Barclays. They are expected to issue yearly earnings well above the market consensus of 5.3 billion, but the share are so cheap that entire company is valued at a mere 7.8 billion. This puts it on an amazingly low P/E ratio of 1.47. In other words, if you bought the entire company and it managed to replicate last year's earnings, after one and a half years you would have made all your money back (very roughly speaking) and you would then have a free bank on your hands. Alas, the outlook for future earnings for the banking sector is not so bright.

With hindsight, it's obvious why the ratios are out of whack and how they will correct, but the reality is less clear. Should we look to the numerator or denominator, or both? History can be a guide, but humility in the face of uncertainty is called for.