S&P P/E Ratios: Following the Icarus Flight Plan

The Dow rose 11 points on Friday, or 0.11%. Binary code enthusiasts aside, that’s not much to get excited about, neither for bulls nor bears. In fact, the past couple of months have pretty much been a wash. Both the Dow and the broader S&P 500 sit more or less where they began the year. So, where to from here?

Your editor has no idea where the markets will go…only an inkling of where they ought to go. And where they ought to go is back to the mean, as everything eventually does. Right now, the S&P goes for around 22-25 times earnings, considerably higher than the long-term mean, which Yale University’s Robert Shiller has at 16.35.

Typically, investors do well to buy stocks when they are trading at between 5-10 times earnings. For instance, you could have bought the S&P for slightly less than 5 times earnings in the early 1920s. As we know, the index topped out later that decade, on Black Tuesday…when the P/E ratio hit 30. Provided you adhered to the mean reversion rule and sold before that fateful day, you could have bought the index back in ’32, again for around 6 times earnings. (It then rallied/bounced – to right around where it is now – before slipping back below 15 shortly after.)

For the better part of the next seven decades, the S&P 500 flew cautiously under the 25-times-earnings radar, on a handful of occasions even ducking back below 10. It wasn’t until the easy money days of the mid-’90s that the index waxed up its wings and launched into the clear blue sky. For a while, it looked as though nothing could spoil the flight. Then, in December of 1999, at the lofty P/E height of 44.2, the wax started to melt. The rest, as they say, is very modern history.

All this is not to say that the S&P is about to dive into the sea tomorrow. It’s more of a polite reminder to keep an eye on the altitude…

The Daily Reckoning