Friday, May 22, 2009

PE Ratios at Historical Levels - What Does it Mean?

Last week's "Chart of the Week" (posted May 15th) illustrated the current plunge of S&P 500 earnings. Today's chart illustrates how this plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the current plunge in earnings and the recent 2.5 month stock market rally, the PE ratio has spiked to the low 120s – a record high.

I do not believe the market's current PE ratio signals the market to be overvalued. Rather, this statistic indicates the market is anticipating earnings to return to normal levels soon. An increase in earnings would quickly bring PE ratios back to historical levels. However, I would expect this ratio to drop soon even if earnings don't recover, because if earnings (the denominator) don't increase, stock prices (the numerator) will likely fall.

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