When discussion of market valuation comes up, the mention of price-to-earnings ratios (p/e ratio) is often brought up to possibly explain if the market is overvalued or undervalued. The arguments generally follow along the line of reasoning that when the stock market rises then so too will the p/e ratio, which will be indicated when the market is overvalued on a relative basis. Alternatively, when the stock market is in a declining trend, the p/e ratio will also decline to historical lows allowing for a good indication of when the market is undervalued. The point usually is that there is a correlating relationship between the rise and fall of the stock market and p/e ratios.
While the line of reasoning regarding p/e ratios and stock market valuation is logical and can easily be demonstrated over a majority of stock market history, there have been periods when an inverse relationship between the stock market and the p/e ratio suggests a shift in market direction. The periods of an inverse relationship should shed light on the challenges and limits of using p/e ratios for determining market valuation. The following are examples of periods where high p/e ratios represented a stock market that either has nearly bottomed or was about to take off and periods when a low p/e ratio indicated that the market was about to trade in a range or decline.
Starting with the first example of an inverse relationship between the S&P 500 (SPY) and the p/e ratio (data compiled by Robert Shiller; please note that the S&P 500 index did not exist before 1957) was the period of 1905 as seen in the chart below.
The short period of time that this conflicting signal occurred was followed by both the inflation-adjusted S&P 500 and the unadjusted Dow Jones Industrial Average (DIA) being mired in substantial underperformance in the period from 1905 until 1924-27 as seen in the charts below.
According to Robert Shiller's work, on an inflation adjusted basis, the S&P 500 meaningfully broke above the 1905 level in 1927 while the Dow Jones Industrial Average achieved new heights after 1924. Within this extended period of time from 1905 to 1927, the inverse relationship between the real S&P 500 index and the p/e ratio occurred again during June 1913-November 1914 period, where the index declined while the p/e ratio increased. This was followed by an increase in the real S&P 500 from December 1914 to December 1915 before the overall decline continued to the 1921 low.
The low of the stock market in 1921 was punctuated with the stock market exceeding a p/e ratio of 50 times before going into deficit due to a lack of earnings. This happened to be the time when the Dow Jones Industrial Average was at 65 before going to the 1929 high of 381 and the real S&P 500 at 83 before the 1929 high of 416, as tabulated by Shiller-S&P.
Another significant period when the p/e ratio of the market declined in the face of a rising market was January 1929 to November 1929. During this period, The Dow Industrials increased from 296 to 381 and the real S&P 500 increased from 311 to 416, or 27% and +33%, respectively. The chart below shows the p/e ratio for ALL S&P Industrials in the period from January 1928 to November 1929 (source: Fisher, Kenneth. The Wall Street Waltz. Contemporary Books, Chicago. 1987. page 68-69).
This is an instance where the stock market still had plenty of room to run on the upside in 1928 and much less upside potential as 1929 was coming to an end. The performance of the S&P 500 after this mixed signal was -80%. In the January to November 1929 period, the Dow Industrials saw the p/e ratio decline from 19 to 14.
Punctuating the inverse relationship between p/e ratios and the market's valuation was the period from 1932 where the p/e ratio for the Dow Jones Industrial Average rose well above 50 and ultimately went into deficit at a time when the stock market, despite the onset of the "Great" Depression, was to move higher and never look back.
The next period of a clear inverse relationship between the stock market and the p/e ratio was from 1934 to 1937 as indicated in the chart of the Dow Jones Industrial Average below.
The culmination of this inverse relationship was the 1937 peak in the Dow Jones Industrial Average, which was followed by a -50% decline in the index to the 1942 low. As the market declined from the 1937 peak, the p/e ratio for the Dow Industrials began to rise to above 25 times in 1938. The Dow Industrials, with the p/e ratio catapulting from the low of nearly 14 times in 1937 to over 25 times in 1938, gained +50% from March 1938 to November 1938.
The next period of divergence between the stock market and its respective p/e ratio was from 1960 to 1973 when the Dow Industrials rose from 700 to 1,050 as the p/e ratio declined from 21 times to 11 times. The Dow Jones Industrial Average was not able to meaningfully exceed the 1,000 mark until 1982.
This same scenario has been played out in individual stocks, with the p/e ratio declining as the stock rises and the p/e ratio rising substantially as the stock declines. Our interpretation of these significant "outliers" is that they may render the use of p/e ratios, as a determining factor of market under/overvaluation, relatively challenging. This does not mean that such ratios cannot be useful for valuation metrics. Instead, it suggests that such a consideration should be put into proper perspective with the understanding that there is a limit to the value that price-to-earnings ratios can provide in determining market valuation.
To us, the most important element that needs to be incorporated when considering the p/e ratio is when it didn't seem to work as expected for the respective stock or index. In the examples given above, the exceptions should prove to be instructive when deciding if a favorite stock or index is over-valued or under-valued.