Before tackling the subject of what kind of returns investors can expect from the stock market over their lifetime (and what a "fair" value for the Dow might be), we need to put today's valuations in historical perspective.
To do this, I will first provide a graph of the Dow's 15-year normalized P/E ratio for each year from 1935-2006. For information on how these "normalized" numbers were calculated, please see my earlier post "Calculating Normalized P/E Ratios."
click charts to enlarge
I consider this graph to be something of a conceptual crutch. Everyone cites P/E ratios – even I do, because it's one of the best known measures in investing. Regardless of the audience you're writing for, you can count on them understanding the P/E ratio.
However, presenting P/E ratios is a bit misleading, because I don't really think in terms of P/E ratios – I think in terms of earnings yields. You should too.
The earnings yield is a much easier number to work with. It facilitates comparisons with other possible investments, simplifies the process of estimating the expected rate of return over various holding periods, and just generally makes life a whole lot easier.
The earnings yield is simply the inverse (i.e., reciprocal) of the P/E ratio. Simply put, it's "e" over "p." For example, a stock with a price-to-earnings ratio of 12.5 has an earnings yield of 8%.
Here is a graph of the Dow's 15-year normalized earnings yield for each year from 1935-2006:
Finally, to give you an idea of the role interest rates played during this period, here is a graph showing both the Dow's normalized earnings yield and AAA corporate bonds yields for each year from 1935-2006:
Just look over these graphs for now. I'll discuss the importance of normalized earnings yields in my next post. Without some historical perspective, you may have trouble following that discussion.
Here's a recap of my posts on this topic so far: