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While the WSJ is prepared to consign the PE ratio to the dustbin (see The Decline of the P/E Ratio and Is It Time to Scrap the Fusty Old P/E Ratio?) Barry Ritholtz is one of the few actually asking the question, “What does a falling P/E ratio mean?

Ritholz focuses on the expansion and contraction of the PE ratio as indicative of bull or bear markets:

We can define Bull and Bear markets over the past 100 years in terms of P/E expansion and contraction. I always show the chart below when I give speeches (from Crestmont Research, my annotations in blue) to emphasize the impact of crowd psychology on valautions.

Consider the message of this chart. It strongly suggests (at least to me) the following:

Bull markets are periods of P/E expansion. During Bulls, investors are willing to pay increasingly more for each dollar of earnings;

Bear markets are periods of P/E contraction. Investors demand more earnings for each dollar of share price they are willing to pay.

Hence, a falling P/E ratio is not indicia of its lack of utility. Nor is it proof of “Fustyness.” Rather, it suggests that crowd is still feeling burned by the recent collapse in prices and increase in volatility.

Here’s the chart (click to enlarge):

I think Ritholz’s analysis is excellent as far as it goes, but I think it misses part of the story. The “E” in the PE ratio is also subject to expansion and contraction over the course of the business cycle. Earnings are still normalizing from a period of massive expansion. While the single-year market PE might be at 15.8, which is a little over the long-term average of 15, on a cyclically-adjusted basis, the PE ratio is over 20, which is historically expensive (click to enlarge):

Click to View

Assuming that this time is not different, earnings will contract as they regress to the long-term mean, and the market PE ratio will contract along with earnings.

Source: What Does a Falling P/E Ratio Mean?