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The Price-Earnings Ratio
(Updated 6/25/07)
The Price-Earnings Ratio (P/E) is a measure of whether the stock market is “cheap” or “expensive”. The late 1990’s and early 2000’s was a time when the stock market was expensive. Here is a chart showing the P/E ratio for the S&P 500:
Source: Vanguard.com
It would seem logical that following periods when the stock market is expensive, as evidenced by high P/E ratios, returns would be poor. And if returns are expected to be poor, would it be a good idea to lower one’s stock allocation?
This question was one of many posed to John Bogle at the Diehards Reunion in Alexandria, Virginia on June 11, 2007:
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Question: How to make a choice between “staying the course” and “irrational exuberance”, i.e., should one change asset allocation in order to preserve capital?
Answer: Sometimes, markets are ridiculously cheap, and sometimes they are ridiculously expensive, but that does not happen often, perhaps six times in one’s life. And for middle-aged people, fewer than six of such occasions are left. During extreme times, P/E points in the right direction, e.g., when P/E is 30-32, that is way too high. However, Mr. Bogle does not get out of the market even then. It is difficult, if not impossible, to time major asset allocation moves. He stated emphatically that there is never a right time to abandon the equity market.
· In March 2000, many people were optimistic and poured money into the market.
· In August 2003, many people were pessimistic and took money out. They lost on both occasions.
On the long run, business will bail out markets from their worst mistakes. Today, the P/E is about 18, and that does not warrant any changes. “Capital preservation” should make one more conservative and not touch it. A 7% return would double money over the next 10 years.
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Source: bylo.org
This made me wonder how often the P/E ratio exceeded 30. The answer lead me to Jeremy Siegel’s book Stocks for the Long Run (Third Edition). The following chart appears on page 96:
Source: Stocks for the Long Run (Third Edition)
There are two things that jump out from this chart. First, even when the P/E ratio was high in the past, it did not exceed 30 until the late 1990’s. And second, a high P/E ratio, in and of itself, did not necessarily foretell a period of poor returns. In chapter 6 from Stocks for the Long Run, Jeremy Siegel explains the reason why:
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However, peaks in the P-E ratio are not always bad omens for investors. If a sharp drop in earnings causes the P-E ratio to spike upward, such as occurred in the 1894, 1921, 1938, and 1990-1991 recessions, [and noted by “E” on the chart], real returns following these spikes have averaged a robust 9.7 percent annually over the subsequent 5 years. These returns are high because sharp declines in earnings always have been temporary, caused by recessions or other special circumstances, and earnings as well as stock prices have rebounded subsequently. Nevertheless, the P-E ratio associated with the 2000-2001 recession is so high that investors should not expect above-average returns to prevail.
When surges in stock prices cause P-E ratios to rise, as occurred in September 1929, July 1933, June 1946, November 1961 and August 1987, [and noted by “P” on the chart], 5-year future real returns have averaged only 1.1 percent. Surging stock prices often reflect undue optimism about earnings growth. When faster earnings growth is not realized, stock prices fall, and returns suffer. Certainly the P-E spike that occurred in late 1999 and early 2000 accurately foretold poor future returns.
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Conclusion
The P/E ratio is a common measure of how “cheap” or “expensive” the stock market is valued. However, only on rare occassions does the P/E ratio move to extremes. And even during these extremes, it is necessary to look at the context. For example, the P/E ratio exceeded 45 in 2001 in the midst of a recession and falling earnings. Since that time, the stock market has recovered. The S&P 500 reached an all time high early in 2007. And it had a 5-year annualized return of over 9 percent (nominal) for the period ending May 31, 2007. See Note 1 below.
So should investors alter their portfolios when the P/E ratio moves to extremes? As we have seen, the P/E ratio has not accurately signaled the market’s future direction. And when you combine this with Mr. Bogle’s believe that it is difficult to time major asset allocation moves, it would appear the best course would be to Stay the Course with one’s carefully considered
asset allocation.
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