Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
CATHY WOOD ARK GARBAGE ARK Funds Heading for 90% STOCK CRASH! - 22nd Jan 22
Gold Is the Belle of the Ball. Will Its Dance Turn Bearish? - 22nd Jan 22
Best Neighborhoods to Buy Real Estate in San Diego - 22nd Jan 22
Stock Market January PANIC AI Tech Stocks Buying Opp - Trend Forecast 2022 - 21st Jan 21
How to Get Rich in the MetaVerse - 20th Jan 21
Should you Buy Payment Disruptor Stocks in 2022? - 20th Jan 21
2022 the Year of Smart devices, Electric Vehicles, and AI Startups - 20th Jan 21
Oil Markets More Animated by Geopolitics, Supply, and Demand - 20th Jan 21
WARNING - AI STOCK MARKET CRASH / BEAR SWITCH TRIGGERED! - 19th Jan 22
Fake It Till You Make It: Will Silver’s Motto Work on Gold? - 19th Jan 22
Crude Oil Smashing Stocks - 19th Jan 22
US Stagflation: The Global Risk of 2022 - 19th Jan 22
Stock Market Trend Forecast Early 2022 - Tech Growth Value Stocks Rotation - 18th Jan 22
Stock Market Sentiment Speaks: Are We Setting Up For A 'Mini-Crash'? - 18th Jan 22
Mobile Sports Betting is on a rise: Here’s why - 18th Jan 22
Exponential AI Stocks Mega-trend - 17th Jan 22
THE NEXT BITCOIN - 17th Jan 22
Gold Price Predictions for 2022 - 17th Jan 22
How Do Debt Relief Services Work To Reduce The Amount You Owe? - 17th Jan 22
RIVIAN IPO Illustrates We are in the Mother of all Stock Market Bubbles - 16th Jan 22
All Market Eyes on Copper - 16th Jan 22
The US Dollar Had a Slip-Up, but Gold Turned a Blind Eye to It - 16th Jan 22
A Stock Market Top for the Ages - 16th Jan 22
FREETRADE - Stock Investing Platform, the Good, Bad and Ugly Review, Free Shares, Cancelled Orders - 15th Jan 22
WD 14tb My Book External Drive Unboxing, Testing and Benchmark Performance Amazon Buy Review - 15th Jan 22
Toyland Ferris Wheel Birthday Fun at Gulliver's Rother Valley UK Theme Park 2022 - 15th Jan 22
What You Should Know About a TailoredPay High Risk Merchant Account - 15th Jan 22
Best Metaverse Tech Stocks Investing for 2022 and Beyond - 14th Jan 22
Gold Price Lagging Inflation - 14th Jan 22
Get Your Startup Idea Up And Running With These 7 Tips - 14th Jan 22
What Happens When Your Flight Gets Cancelled in the UK? - 14th Jan 22
How to Profit from 2022’s Biggest Trend Reversal - 11th Jan 22
Stock Market Sentiment Speaks: Are We Ready To Drop To 4400SPX? - 11th Jan 22
What's the Role of an Affiliate Marketer? - 11th Jan 22
Essential Things To Know Before You Set Up A Limited Liability Company - 11th Jan 22
NVIDIA THE KING OF THE METAVERSE! - 10th Jan 22
Fiscal and Monetary Cliffs Have Arrived - 10th Jan 22
The Meteoric Rise of Investing in Trading Cards - 10th Jan 22
IBM The REAL Quantum Metaverse STOCK! - 9th Jan 22
WARNING Failing NVME2 M2 SSD Drives Can Prevent Systems From Booting - Corsair MP600 - 9th Jan 22
The Fed’s inflated cake and a ‘quant’ of history - 9th Jan 22
NVME M2 SSD FAILURE WARNING Signs - Corsair MP600 1tb Drive - 9th Jan 22
Meadowhall Sheffield Christmas Lights 2021 Shopping - Before the Switch on - 9th Jan 22
How Does Insurance Work In Europe? Find Out Here - 9th Jan 22
MATTERPORT (MTTR) - DIGITIZING THE REAL WORLD - METAVERSE INVESTING 2022 - 7th Jan 22
Effect of Deflation On The Gold Price - 7th Jan 22
Stock Market 2022 Requires Different Strategies For Traders/Investors - 7th Jan 22
Old Man Winter Will Stimulate Natural Gas and Heating Oil Demand - 7th Jan 22
Is The Lazy Stock Market Bull Strategy Worth Considering? - 7th Jan 22
METAVERSE - NEW LIFE FOR SONY AGEING GAMING GIANT? - 6th Jan 2022
What Elliott Waves Show for Asia Pacific Stock and Financial Markets 2022 - 6th Jan 2022
Why You Should Register Your Company - 6th Jan 2022
4 Ways to Invest in Silver for 2022 - 6th Jan 2022
UNITY (U) - Metaverse Stock Analysis Investing for 2022 and Beyond - 5th Jan 2022
Stock Market Staving Off Risk-Off - 5th Jan 2022
Gold and Silver Still Hungover After New Year’s Eve - 5th Jan 2022
S&P 500 In an Uncharted Territory, But Is Sky the Limit? - 5th Jan 2022

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

What the PE Ratio can tell us about the Future Stock Market Direction

InvestorEducation / Corporate Earnings Feb 27, 2007 - 12:20 AM GMT

By: Hans_Wagner

InvestorEducation

S&P 500 earnings are on track for a 20% gain compared to last years 3 rd quarter. Next quarter earnings should rise about 11%, marking the fifteenth straight quarter of a double-digit gain. Along with the excellent earnings performance we have experienced dramatic strength in the major averages as well. The DJIA is at all time highs and the S&P 500 is above 5 year highs.

The outlook for continued good performance in both earnings and the indices remains strong. Given this positive outlook, I thought it might be appropriate to see if stock valuations are getting ahead of themselves by looking at current and past PE ratios.


First, just to be sure we all know what is meant by the PE ratio. It is a ratio of a company's current share price compared to its per-share earnings. Calculated as:

This means if the value per share goes up faster than the earnings per share, then the PE ratio goes up. The higher the PE ratio the more lofty the valuations and the greater the potential for the market to overheat, resulting in a pull back. This happened in 2000. If earnings move up faster than the value per share, then the PE ratio will decline. This happens when the market is transitioning from an overbought situation even as earnings increase. The point is that both stock prices and earnings drive the PE ratio.

With most all of the S&P 500 companies having reported their earnings, it turns out that the PE ratio for the S&P 500 for the 3 rd quarter of 2006 is 17.5. This is still above the average of 16, though it is trending down. The table below displays the PE ratio for the S&P 500 for the last 9 quarters. As you can see it has fallen from 20.5 in the 3 rd quarter of 2004 to 17.5 in the latest quarter. So even with the nice move up in the S&P 500, the PE ratio has fallen, driven by double digit earnings growth.

S&P 500 PE Ratio

Q3 2004

Q4 2004

Q1 2005

Q2 2005

Q3 2005

Q4 2005

Q1 2006

Q2 2006

Q3 2006

20.5

20.3

20.1

19.5

18.4

18.1

17.8

17.8

17.5

 

Now let's look at the bigger picture. Below is a chart from Robert Shiller, a Yale economics professor and author of Irrational Exuberance: Second Edition . First, notice that the PE ratio is a mean reverting index, meaning that when it moves away from the average it will eventually move back to average. In fact, it normally goes past the average in a cyclical motion. I also put a plus sign (+) indicating where the PE is as of the 3rd quarter 2006 (17.5). The trend is down from a high in 2000. If history repeats itself, as it usually does, we can expect the S&P 500 PE ratio to penetrate 16 and then go lower, with 10 a possibility in the next several years. In order for this to happen earnings will have to go up over 70% with stock prices remaining essentially flat, or stock prices would have to go down over 40% with earnings remaining flat. Those are scary thoughts.

The chart above was derived from Robert Shiller is the Stanley B. Resor Professor of Economics at Yale and author of Irrational Exuberance: Second Edition . Robert Shiller's web site I added the average line and the plus sign (+) indicating the 3 rd quarter 2006 PE ratio.

So what does this mean to investors? There are many possible scenarios, however, lets briefly look at three. First, we continue on the same PE ratio trend with earnings growing faster than the valuation of the S&P 500. The ratio will hit 16 and then fall below that over the next 5 to 8 years. Should earnings growth slow down then the rise in stock prices will have to slow down as well, possibly going flat to down. This is the green line option. Second option, the PE ratio falls to 10 in the next 2 years. This implies a rapid drop in the price of stocks. This is the black line option. Third, the PE ratio reaches the average of 16 and then moves back up as valuations increase. Stock prices either maintain their current levels or move higher. When the ratio hits 16 the market starts a new bull market and valuations grow faster than earnings. This is the brown line option.

The direction the PE ratio takes will have a significant impact on investors. While it would be great to accurately predict the correct scenario, we need to recognize that the probability of correctly making this prediction is low. We are better served to be prepared to accept any likely scenario as the market shows itself using the PE ratio trend as one of the important long term indicators that needs to be monitored. As such we will revisit what is happening to the S&P 500 PE ratio and how we use the insight it offers. For now expect the ratio to fall to its long term average of 16 form the current average of 17.5. 

This will require earnings to continue to grow faster then stock prices over the next several quarters. Current forecast are for 11% earnings increase in the 4 th quarter of 2006. With the S&P 500 up 9.6% so far this year, that doesn't leave much room for prices to move higher and still have a falling PE ratio. We are in the best time of the year for stock price performance, so a small expansion in the PE ratio is not a move away from the long term trend. In any case I do not see a significant increase in stock price valuation for now. We will need to make another assessment in 3 months.

By Hans Wagner tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

narendra
20 Jul 07, 20:45
P.E.Ratio.

I have never read such an excellent article.I like to know is there any book writtern by you on this subject.Pl.inform me.Thanks.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in