Molodovsky Effect: Understanding Market Inverted Cycles

The Molodovsky Effect is the imperial observation by Nicholas Molodovsky that at the bottom of an economic cycleEconomic CycleThe economic cycle is the fluctuating state of an economy from periods of economic expansion and contraction. It is usually measured with the, P/E ratios are high, and earnings are low. However, at the top of an economic cycle where there is an economic boom, the P/E ratios are low, and earnings are high.

The Molodovsky Effect came to light in 1953 when Nicholas Molodovsky published the article “A Theory of Price Earnings Ratio” in the Financial Analyst Journal. It occurs because when the economic cycle is at the bottom, companies are generally earning less. Thus, the denominator of the P/E ratio decreases, pushing the P/E ratio up.

Furthermore, it is said that the decrease in the earnings outweighs the price decrease, which pushes the P/E ratio up. In contrast, when the economic cycle is at its peak and companies’ earnings are high, the denominator of the P/E ratio increases, which puts downward pressure on the P/E ratio.

It is counterintuitive against the belief that growth stocksGrowth StocksGrowth stocks are stocks that offer a substantially higher growth rate as opposed to the mean growth rate prevailing in the market. It means that a growth demonstrate high P/E ratios and value stocksValue StocksValue stocks are stocks that are currently trading at a price lower than their actual intrinsic price. It basically means that the stocks are undervalued, take on low P/E ratios. The earnings in the P/E ratio are forward-looking; growth stocks with higher future earnings would see a lower P/E ratio, whereas value stocks with lower future earnings would generate a higher P/E ratio.

The Molodovsky Effect and P/E Ratios

P/E ratios are calculated by dividing the current price of a stock by its current earnings or expected earnings. Using expected earnings to calculate the P/E ratio would yield the forward P/E ratio. However, using a time-weighted average P/E ratio or the CAPE ratioCAPE RatioThe CAPE Ratio (also known as the Shiller P/E or PE 10 Ratio) is an acronym for the Cyclically-Adjusted Price-to-Earnings Ratio. The ratio is calculated by dividing a company's stock price by the average of the company's earnings for the last ten years, adjusted for inflation. would not be effective in analyzing the Molodovsky Effect.

The CAPE ratio refers to the cyclically adjusted price-to-earnings ratio and is calculated by dividing the stock’s price by the average earnings over the past ten years. The ratio can be used to filter out any noise in the P/E ratio data, such as anomalies, seasonal changes in stock, or fluctuations throughout the economic cycles.

Since the CAPE ratio or a time-weighted P/E ratio (average 20-year P/E ratio) adjusts for fluctuations in the economic cycle, it should not be used to analyze the Molodovsky Effect. Instead, a shorter-term P/E ratio should be used to be able to analyze such an effect.

Issues with the Molodovsky Effect

The main issue with the Molodovsky Effect is that it may not always hold or be correct for certain stocks. For example, some industries are not impacted negatively by economic downturns and consequently generate steady or strong earnings, which would not push their P/E ratio up.

Also, with an increase in participation in capital markets and improvements in technology and liquidity, the Molodovsky Effect may not be as prevalent.

The Molodovsky Effect in Practice

In practice, the Molodovsky effect is not referred to excessively. However, it is something that analysts and researchers should be aware of when researching or analyzing stocks.

Also, it is useful to understand how the Molodovsky Effect works in different industries. It can also be a useful tool when comparing stocks or industries.

Summary

• The Molodovsky Effect was first published in 1953 by Nicholas Molodovsky in the Financial Analyst Journal.
• At the bottom of an economic cycle, earnings tend to be low, which puts upward pressure on the P/E ratio.
• At the top of an economic cycle, earnings tend to be high, which puts downward pressure on the P/E ratio.
• Short-term P/E ratios are ideal for observing the Molodovsky Effect. In contrast, time-weighted P/E ratios or the CAPE ratio would flatten out any cyclical changes in the economy and make the Molodovsky Effect unobservable.

Related Readings

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