Aside

Is the Price Right?

The fundamental method for valuing a stock, and the entire market, is the Price to Earnings Ratio (or PE Ratio). So what constitutes good value: what is a low PE Ratio? Historically, the PE Ratio of the S&P 500 has averaged around 16 over the past hundred years.

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But there has been a definite increase in PE Ratios recently (the entire bull market of the 1990s began and was sustained with PE Ratios above 16) so we need to look at recent examples of the market’s highs a lows to judge its limits.

What was the PE Ratio before major, recent crashes?

  • When the mortgage bubble hit its height in October 2007 the PE Ratio was 27.31. The market crashed shortly after.
  • When the dot com bubble hit its height in March 2000 the PE Ratio was 43.22. Again, the market crashed thereafter.

And what was the PE Ratio before major, recent bull markets?

  • When the market began its recovery in March 2009 (after the 2007 mortgage bubble and 2008 stock market crash) the PE Ratio was 13.32
  • When the market began its bull run on March 2003 (after the 2000 dot com bubble and 9/11, and their respective stock market crashes) the PE Ratio was 21.31

So we can conclude that PE Ratios above 27 are possibly high and the PE Ratios below 22 are possibly low. Of course, there are many other factors to consider before predicting future bull or bear markets, but the PE Ratio is a good place to begin. Today’s PE Ratio of 22.73 is quite low, but not indicative of the beginning of a major advance.

It is important to note that these limits are a means to judge the overall market (i.e., the entire S&P500) rather than individual stocks. Just because a stock has a PE Ratio of less than 22 does not mean I will buy it. In fact, as a value investor, my policy is never to buy a stock with a PE Ratio above 20 and I generally look for stocks with a PE Ratio of 17 or less.

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