Sam RoJul 19, 2014, 01.22 AM
One of the most common ways to measure stock market value is to take the price and divide it by earnings. This is the price-earnings, or P/E, ratio.
Trading at a P/E of around 16 times expected earnings, the S&P 500 appears to be expensive.
But this is not to say that investors should dump stock because a sell-off is imminent.
In fact, history shows that these P/E ratio will often drift away from long-term average for long periods of time.
But this also doesn’t mean we should completely ignore what P/E ratios are telling us.
It turns out that the predictive power of P/E ratios becomes more precise the longer your time horizon.
"History suggests that market valuation tells us little about near-term market direction," writes Alliance Bernstein’s Seth Masters.
Masters demonstrates this with two absolutely brilliant charts. Here’s his language:
The left side of the second display … portrays one-year returns for the S&P 500, arrayed by the price-to-forward earnings at the beginning of each period. When the market has previously been close to its current valuation, there has been a very wide range of returns in the subsequent year. That was also true when valuations were lower or higher. Basically, stocks can be very volatile in the short run, and the market could rise or fall significantly over the next year regardless of its valuation.
If you extend your time frame, however, the behavior of the market looks much more predictable. The right side of the display shows that with a five-year horizon, the range of market returns has been narrower. Furthermore, valuation has mattered over longer horizons: when the price-to-forward earnings has exceeded 20, the subsequent five-year S&P 500 return has, in most cases, been low or negative.
Here’s Masters’ charts with a few skitches showing how the range of observed annualized returns at a given valuation narrow when you extend the time horizon.
Alliance Bernstein
"We think that current stock market valuations are not a clear signal of what will happen in the next year or two," wrote Masters. "Stocks could drop, and if they did, we’d likely see it as a buying opportunity. Or the market could soar, possibly to a point where we would recommend paring back. But, most likely, we’ll see modest returns in the next few years."