Getting On The Right Side Of The P/E Ratio Trend

By Hans Wagner AAA

John Templeton, of Templeton Funds, says to "buy bargains," meaning, buy stocks when they are at their best value. When the market is at a low, investors find the best bargains. More specifically, this means when the P/E ratio is at a low point, as investors experience the best returns by buying when P/E ratios are low and selling when P/E ratios are high. That makes sense, as the value of stocks and the market increases when the P/E ratio rises. Buying when the market P/E ratio is at a high level increases the risk that you will experience a negative return, whereas buying when the P/E ratio is at a low point significantly increases the likelihood you will experience high returns in the subsequent years.

Changes in earnings and the P/E ratio determine the value of stocks and of the stock market. Yale Professor Robert J. Shiller, author of "Irrational Exuberance", has maintained his excel spreadsheet of important market data that is available to anyone. (To learn more, see Ten Books Every Investor Should Read.)

Charting History
The charts below are from Professor Shiller. Investors who were fortunate to buy when the market P/E ratio was at or below 10 in 1920, 1950 or 1982 received excellent returns in the years following. In each case, the P/E ratio expanded as the S&P 500 climbed to new highs.

On the other hand, investors who bought into the market when the P/E ratio was at its highest in 1929, 1969, 2000 and 2008 experienced significant losses. In each case the P/E ratio contracted as the market plunged.

This raises the question. What is the primary determinant of the P/E ratio?

It turns out that inflation, and especially expectations of inflation, are very important in determining the P/E ratio and its trend. As inflation rises and market prices become more volatile, the markets P/E ratio tends to fall, whereas low and stable inflation leads to rising P/E ratios and a bull market.

Bull Markets
During the bull market of 1950-1963, investors experienced the classic case of an up-trending P/E ratio, as the inflation rate remained low and stable. Initially, inflation as measured by the CPI ramped up quite high during the war in Korea. It then fell, and stayed low and stable throughout the rest of the bull market. The S&P 500 P/E ratio started out just above 10 and climbed to over 20. It was a nice time to be in the market.

In the 1982-2000 bull market, inflation as measured by the CPI started at 7% and declined to almost 1%. Along the way, the S&P 500 P/E ratio climbed from well below 10 to almost 45. Inflation remained volatile, ranging from 1-6% until mid-1991 before stabilizing. Once inflation showed stability in 1994, the P/E ratio started to expand at a steeper rate, reflecting these more stable inflation rates. Many investors did well as they benefited from the expansion of the P/E ratio in the market.


Bear Markets
The market does not like uncertainty, especially when it comes to the prices for goods and services. Periods of price instability leading to rising inflation or falling into deflation lead to falling P/E ratios. Investors who bought the market during periods of price instability experienced fluctuating P/E ratios that trend down.

The bear market that began with the 1929 crash saw deflation raising its ugly head with the CPI falling to -10.7% in 1932. From that low, the CPI fluctuated significantly rising to over 13% in 1942, falling to 0% in 1944 and then jumping up to 19.7% in 1947 before plunging below zero in 1949. This period of instability in the CPI kept the P/E ratio at a low level, dropping to 10 or lower multiple times. (For more, see What Caused The Great Depression.)

Bear markets often begin when inflation is low, though there are concerns it will rise in the future. Expectations for higher inflation lead to lower P/E ratios and falling market values as the P/E ratio trends down or sideways. The bear market of 1964-1982 is a good example of this relationship. The S&P 500 P/E ratio started out in the 20-25 range with inflation below 2%. Over time, inflation rose, reaching over 14% as the S&P 500 P/E ratio fell from 24 to less than seven. During this time, the market fell and many stock investors experienced long-term losses.

The bear market that began in 2000 also started with a high P/E ratio on the S&P 500. In this case, inflation started at a relatively benign 3.73%. From there, it trended down and reached 1% before turning up reaching 5.6% in July, 2008. During this time, the S&P 500 P/E ratio fell and then moved sideways as the market worked through the after affects of the dotcom bubble. (For more, check out Riding The Market Bubble: Don't Try This At Home.)

With the end of the dotcom bubble, the market rose on earnings growth - not expansion - of the P/E ratio. From 2002-2008, inflation ranged, from 1% to a high of 5.6%. This volatility in the inflation rate, helped to keep the P/E ratio in a narrow range, just above 25 for most of this time, a relatively high level based on historical comparisons.

The market crash that began in 2008 took the CPI from over 5% to -2%, as the U.S. once again flirted with deflation. The S&P 500 P/E ratio fell to just below 15 before it turned up. In this case, the P/E ratio never fell below 10, as it had in prior bear markets.

Beginning in 2008, rising inflation turned to deflation, increasing price instability. As we have seen, price instability leads to a declining P/E ratio. Deflationary conditions are another form of price instability that has led to falling P/E ratios. If price stability returns, investors can expect to see the P/E ratio rise. On the other hand, if inflation returns and the CPI rises significantly, rather than find a low stable level, investors should expect the P/E ratio to trend down or at best sideways.

Conclusion
Rising inflation, the expectation of rising inflation and instability in the rate of inflation will cause the P/E ratio to trend down. On the other hand, if inflation remains at a stable and low level, it is a positive for the markets and investors can expect the market P/E ratio to climb. This is especially true when the P/E ratio is at a level below 10.

It pays for investors to be on the right side of the trend. Since the rate of inflation affects the P/E ratio, we need to be aware of the rate of inflation. More importantly, we need to assess the future trend and volatility for inflation as it influences the P/E ratio. (To learn more, see our P/E Ratio Tutorial.)

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