Warning from the Price-Earnings Ratio

The price-earnings ratio is one of the most widely used investing metrics. Simply put, it's the ratio of the price of a share of stock compared to its earnings per share. One can use past earnings (typically, the past 12 months), or predicted future earnings (typically, the next 12 months). Past earnings tend to be a more solid number, although they didn't work out real well in the case of Enron, or some other companies that turned out to have fabricated earnings. Predicted future earnings is theoretically a more significant number, since stock values tend first and foremost to be based on anticipated future performance of the company. But one investor's prediction is another investor's fantasy. The accuracy of the prediction makes all the difference in the world.

Low p/e ratios are viewed as indicating stocks are cheap. High p/e ratios are usually taken to mean stocks are expensive and perhaps headed for a fall, or else speculative (i.e., based on the hope of a rise, and perhaps a big rise, in future profits).

By and large, the S&P 500 has a historical average p/e ratio of around 15 (based on past earnings). In the stock market boom of the late 1990s, the S&P 500's p/e ratio spiked up into the 40s. In the late 1990s, the U.S. economy was riding a wave. A huge peace dividend from the end of the Cold War pumped up the private sector as defense spending fell. The United States avoided major military conflicts, and enjoyed large gains in productivity. The economy benefited from cheap money provided by the Federal Reserve (probably too much and too cheap). The Silicon Valley and other tech centers blossomed. The economic outlook was rosy, and avid investors pushed the p/e ratio to 40+. We now know it meant stocks were quite speculative and volatile.

After the 2000-01 tech stock crash, the S&P 500 settled into the mid-20s during the early to mid-2000s. Last year, when the stock market crashed, the ratio dropped to the 15-20 range. Considering how gloomy things looked, a p/e ratio of 15 may have seemed pretty optimistic.

One might argue that this year's stock market rally vindicated last fall's relatively congenial p/e ratio. But the economic picture creates cognitive dissonance. We have a feeble real estate market, rising unemployment, spasmodic job creation, likely federal tax increases, limited ability of the government to authorize more stimulus spending, and an American public scared shirtless into saving. Just about the only thing that explains the 60% rally this year is the relentlessly accommodative Fed, which pumped out printed money like it was beer at a frat party. That money wasn't loaned to Main Street, but had to go somewhere. The stock market was one popular destination.

Today's S&P 500 p/e ratio based on the past 12 months of earnings is 72.83 (see http://online.wsj.com/mdc/public/page/2_3021-peyield.html). That's well above the speculative peak of the tech stock boom. When almost all prognostications for economic recovery are guardedly cautious, or else cautiously guarded, such a high p/e ratio seems to indicate that corporate profits will grow at a dazzling rate next year, or that the market is on very thin ice. Few predict the former. At the same time, the Fed can't keep pumping out printed money. It may even take the radical step of withdrawing a bit of it. Think of what happens to a frat party if the beer runs low. Today's p/e ratio tells you that if you buy the market now, view your investment as a long term bet.