S&P 500′s P/E Drops to 21-Year Low

Thanks to the market’s recent sell-off, the Price/Earnings Ratio for the S&P 500 is now at a 21-year low. The S&P 500 is currently going for just 13.43 times trailing earnings. That’s an earnings yield of close to 7.5%. The market’s P/E Ratio hasn’t been this low since November 1990.

Here’s a look at the S&P 500 in the black line along with its earnings in the gold line. The black earnings follows the left scale and the gold line follows the right. The two lines are scaled at a ratio of 16-to-1 which means that the market’s P/E Ratio is exactly 16 whenever the two lines cross.

Obviously, the future part of the earnings line is based on Wall Street’s forecast. I should caution you that Wall Street has been known to be wrong about these things.

Here’s a look at the S&P 500′s P/E Ratio:

The P/E Ratio reached a peak of 30.4 on January 4, 2002. This means that valuations have dropped by 55% in nearly a decade.

The P/E Ratio is a good measure of valuation but it’s not the only one you should use. Like all others, it has some problems and we may be seeing why right now.

The problem with the P/E Ratio is that the earnings line looks backwards in time while current stock prices always peer into the future by a few months. Due to this mismatch, the P/E Ratio can give you false readings.

For example, the ratio could be artificially low right now. Instead of indicating a cheap market, it may be the result of stocks forecasting lower earnings. That would mean higher trailing earnings are being divided by declining stock prices. That, in turn, would cause the ratio to fall.

Conversely, during the initial stage of a bull market, the P/E Ratio often rises even though stocks continue to rally. Again, it’s not necessarily a sign of high valuations but rather of stocks anticipating strong earnings growth in the near future. Look at how the black line jumped in 2009 before the gold line eventually turned.

Posted by on August 3rd, 2011 at 10:48 am

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