Price to Earnings Ratios

The price to earnings ratio (P/E) is the most common valuation metric applied to stocks. The higher the P/E, the more expensive the stock.

P/E has many shortcomings. The 'E' represents net income as determined by accounting convention. Accounting earnings can be subject to considerable manipulation and often do not reflect the true cash earning power of an enterprise.

Another drawback is that the 'E' typically reflects a 12 month performance window. Company performance is sure to change over time, so basing valuation on a one year time frame can be short cited.

Moreover, Wall Street is notorious for using earnings estimated by analysts for the next 12 months when generating P/Es. Research suggests that analysts are overly optimistic when forecasting the future, meaning that the so called 'forward' P/Es provide an illusion of value that often disappears when P/Es are based on 'trailing' (i.e., trailing 12 month or TTM) performance.

Finally, P/Es often appear most attractive when business cycles have peaked. Cyclical expansions increase earnings. Higher earnings drive P/Es lower, and those lower P/Es can entice investors into thinking that they are buying stocks on the cheap just before cycles turn down. This missive from my friend Vitaliy suggests that we may be facing just such a situation currently.

That said, P/E can still be a useful valuation metric--particularly when employing aggregate P/E measures to assess overall market value. John Hussman is a sharp valuation guy who employs this approach. An example of his work can be found here.

After reading it, answer these questions: Where do we stand currently with respect to overall market P/E compared to history? What is the historical relationship between P/E and future stock returns? What does John Hussman forecast for 10 year market returns given current aggregate market P/E?

position in SPX