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Long term P/E, can the current bull market last, what do you think?

This website has nice plots of data going back 90 years.

If I look at the SP500, and find the date when it reaches a maximum before a long down turn I find:

Date P/E Interest Rate
Aug 1929 21
Jan 1937 16
may 1946 22
Feb 1962 21 4.2
Nov 1968 19 5.7
Jan 1973 17
Aug 2000 29 5.6
Oct 2007 23 4.4

The P/E often rises sharply after the stock prices start to drop, presumably because the earnings then drop faster than the stock prices. This is surprising since the earnings should be delayed w/r to the stock price and stock prices can move faster.
The P/E usually drops by a factor of 2 or more before the start of a new bull market, although in Feb 2009, when the recovery started from the great recession the P/E was 104
Intuitively I would expect stocks to be a good investment, if the P/E is less than 1/(interest rate), but the data does not seem to support this.

Today the P/E for the SP500 is 25, I wonder how much higher stock prices can go?

5 responses

As a great man once said, "the market can stay irrational longer than you can stay solvent."

Does it even matter? Stocks were overvalued in 1996-2000 and 2004-2008. You'd need to wait out 4 years to be proven right, while everyone else around you had mad gains. OOORRRR have a tactical allocation strategy and don't worry about the CAPE. Que sera, sera.

In my experience just trading, the market can take a VERY long time to adjust even when things are clearly out of whack. Case in point- the housing crisis. Around 2004 the valuations were not making sense to me as a rental property investor, I was young and spent a lot of time trying to figure out what I was doing wrong that these other buyers could have any sort of positive returns on the properties with the rents they were generating. It turns out, they could not, but it took a solid 4 years for that to really sink in and have prices swing back to normalcy. In 1998 you might have thought the market was overvalued and nuts, but it took until March of 2000 to peak.

The market is at least partially irrational. And while trends will eventually revert to the mean, I have been burned in the past by trying to predict when- it almost always takes longer than you think it will (in my experience anyway). You will be quite frustrated when you know are "right" for a period of YEARS yet prices are ignoring that- and your returns are suffering.

A couple things:
1) PE ratios are highly correlated to the prevailing interest rates. C.P., If today's stocks were priced at what many people consider "fair value" PE ratios of 15-20, then they'd be paying out close to 5 or 6% dividends on average. I, being a savvy investor, compare that to today's bonds that are paying out next to nothing and think, "What a deal!" and start buying them up like crazy until the we drive the price to the new "expensive" PE ratios of 25 that we see today, bringing the dividend yield on par to bond yields, with some room for risk premiums and what not. In fact, some traders specifically make money on the spread between interest rates and dividends through SP500 futures and stocks (see this article for an explanation So while the market may seem irrational from the long term view, it is rational in that the market is closing the immediate arbitrage between dividends and bond yields.

2) Earnings can move faster than prices for a couple of reasons. What would you have paid for a generic SP500 company that was losing money in 2009? Surely not 0! So while a PE ratio of 100 seems ridiculous, given the context of the time and the 20/20 hindsight that we have 8 years later, that even looks cheap! This is where the CAPE ratio adds value, as it helps to smooth out these short term movements.

3) There are two ways for PE ratios to go down, either price comes down or earnings go up. If you would have gone short at the end of 2009, when the PE ratios hit 100, you would have lost a your shirt betting on PE ratios to come down - even though you were right - as earnings began to recover

Thanks for the interesting discussion.
I can see another possible effect. If investors anticipate rising interest rates, they may sell their bonds (which will decrease in value as interest rates rise) and buy stocks. Then as more higher interest rate bonds become available, and if they don't anticipate further interest rate increases, sell the stocks and buy bonds. Of course higher interest rates will hurt corporate profits as well. Today the WSJ had an article about how bond prices have started rising.

Its also interesting that the total bond market value is about 1.5X the total stock market value.

I wonder how fast and far the FED can raise interest rates given the size of the national debt? I can see they may need to raise them to allow them to keep borrowing, but raising them also increases the amount of budget that goes to maintaining the debt. Of course there is always more QE.