DAVID LEONHARDT
Thoughts on the economic scene.
The main problem for the stock market is obviously the economy. But it’s not the only problem. Stocks are also under pressure because they are fairly expensive right now relative to earnings.
Graphic: P/E Ratio (Click for Larger Image)My favorite way to look at stock prices is to compare them to corporate earnings over the previous decade. By this measure, the price-earnings ratio for the Standard & Poor’s 500-stock index over the last 50 years has been 19.5. After today’s market drop, the ratio was 20.7.
So stocks would have to fall another 6 percent from their current level to return to the 50-year average.
This version of the P/E ratio is not the most popular one. You’re more likely to see a ratio based on one year of past earnings or on a projection of future. But the 10-year measure has several advantages over the other versions.
It was first recommended, as far as we know, by Benjamin Graham and David L. Dodd, in their classic 1934 textbook, "Security Analysis." Mr. Graham was an important mentor to Warren Buffett. More recently, Robert Shiller, who correctly called both the dot-com bubble and the housing bubble, has argued for using a measure like the 10-year ratio. The data in this post comes from Mr. Shiller’s Web site.
In their book, Mr. Graham and Mr. Dodd urged investors to use a price-to-earnings ratio — that is, stock prices divided by average annual corporate earnings per share — based on at least five years of earnings and, ideally, closer to 10. Corporate profits may rise or fall in any given year, depending on the state of the economy, but a share of stock is a claim on a company's long-term earnings and should be evaluated as such.
Future earnings are even more flawed than short-term past earnings, because Wall Street projections have a pretty weak track record.
Of course, saying that the 10-year P/E ratio is historically high is by no means guaranteeing that stocks will fall. Stocks can remain historically expensive or cheap for many years.
But the 10-year ratio does have a pretty good track record. In 2007, when many Wall Street traders and economists were claiming that stocks were still a great buy, the 10-year ratio knew better. Likewise, it helped predict the market’s rebound in early 2009, when optimists were not easy to find.
That stocks remain expensive is one more reason to be concerned about the economy.
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