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Eddy Elfenbein submits: One of the unusual characteristics of this market is that stock prices have continued to lag earnings growth. I can’t think of a bull market before when price/earnings ratios have declined as the market wore on.

Thanks to the market getting head-butted in the chest this summer, the market’s price/earnings ratio fell to 15, a level it hadn’t seen in over 11 years. Since then, the market has snapped back and the S&P 500 just broke 1,300 for the first time in three months.

Here’s how the S&P 500 and earnings have done since 1990:

The left scale is the for the S&P 500. The right scale is for earnings. I rigged it so when the lines cross, the p/e ratio is exactly 20.

Notice how much higher the blue line is compared with the peak from six years ago. Profits have soared but the index is still much lower. Here's what the market's P/E ratio looks like:

Down, down, down....

What’s interesting is that lower bond yields aren't helping the market’s p/e ratio climb. Normally, lower bond yields allow the market to carry higher earnings multiples. Not this time.

Today, the market’s p/e ratio is about 15.6 (based on trailing operating earnings). That works out to an earnings yield of about 6.4% (1 divided by 15.6). The market’s earnings yield has most often been about 1% to 2% lower than the yield on the 30-year Treasury bond. Now it’s 1.4% higher. (Note: This is slightly different from the Fed model which uses estimated earnings).

Here's how the earnings yield has fared compared with the 30-year Treasury:

The two lines seem to have mirrored each other until a few years ago.

Hey Eddy, I bet you can't scatterplot that.

You guessed wrong my friend:

The horizontal axis is the 30-year Treasury yield. The vertical is the S&P's earnings yield (the inverse of the p/e ratio). Up to about four years ago, the relationship was fairly strong (r^2=0.54). But the relationship has gone kablooey since then.

All the points north of 4.5% and west of 5.5% have come since 2002.

If the market's earnings yield were to match the 30-year yield, the S&P 500 would have to have to be over 28% higher (or long-term yields would have to rise). On top that, earnings are still growing. By my estimate, profits for the S&P 500 should grow in the low double-digits for the rest of this year and 2007.

Source: S&P Breaks 1300