The Market’s Excessive P/E Ratio

There’s recently been some commentary on the stock market’s elevated P/E Ratio (see here and here).
I think this is a good instance where the P/E Ratio fails to tell us much. We have to remember that the P/E Ratio is an unusual statistic because it looks at the relationship between two different kinds of the numbers. A stock’s price is a fixed-point number, which means you know exactly what a price is at any given time, but earnings is a rate, meaning it must be defined at something that only exists between two certain points in time.
There’s nothing inherently wrong about combining two different kinds of numbers though we should be bear in mind its limitations and this is one such time. The reason is that earnings took such a bath in the fourth quarter of 2008. Operating earnings for the S&P 500 were $-0.09 for Q4 of 2008 and reported earnings were $-23.25. As long as we’re carrying that dud quarter in our trailing four quarters, earnings will look very depressed.
Those losses are massive outliers. The good news is that they’re also past us. At the end of the third quarter, the S&P’s trailing four-quarter operating earnings will probably be around $40, at by the end of the fourth quarter, they’ll vault up to $55. That’s simply because we’re subtracting an awful quarter and adding on a more typical quarter. We can expect that the market’s P/E Ratio will dramatically plunge, but that won’t mean that the market is suddenly becoming a good value.

Posted by on August 17th, 2009 at 9:37 am


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