Historically, the average P/E ratio of the S&P 500 is 16.64, and a reversion to said mean would represent a further decline in the index of 29%.
The above comments, and those below, have been edited by Lorimer Wilson, editor of munKNEE.com (Your Key to Making Money!) and the FREE Intelligence Report newsletter (see sample here – register here) for the sake of clarity ([ ]) and brevity (…) to provide a fast and easy read. The contents of this post have been excerpted from an article* by Thomas Barnard originally posted on SeekingAlpha.com under the title Regression To The Mean and which can be read in its unabridged format HERE. (This paragraph must be included in any article re-posting to avoid copyright infringement.)
Mean here is defined as the average.
- The average P/E from 1881 to 2015 is 16.64…
- In 1929 just before The Crash, the P/E ratio was 30.
- For the 65 years from 1930 to 1995, the highest the P/E ratio ever got was 24.
- During the last 20 years, the mean P/E ratio has been 19.03…
- Shiller’s last computation for the P/E ratio was 26.45 which suggests that there is no way that the present P/E ratio can be viewed as [anything] less than high.
If 16 is the P/E’s average, that means that half the time it is below 16, so the stock market could easily drop below the mean, in fact, by half. Bernanke pumped so much air into the balloon that that balloon could pop.
If we take the long term view, and multiplied earnings by 16.64, we get an S&P 500 number of 1316. Given the Wednesday close of 1963 regression to the mean would represent a decline of another 33%.
Would I take money out of the market now? It might be prudent to raise some cash – to take it from your winners and/or from companies with poor management. If stocks do end up going down broadly, it will put you in a position to buy somewhere around the bottom.
Other ways for the P/E to return to more normal numbers is:
- if the earnings were to increase…[but such] is not forecast to rise very much near term.
- if interest rates were to return to more normal rates (which would cause stocks to fall as investors moved into safer rates of return) but the Fed is likely to leave interest rates where they are for now and, because they have left interest rates so low, there is nothing in the cupboard for them to do if things go south again. To some extent, without tools, they have made themselves useless.
Certainly, stocks may bounce back after the big hit on Friday, but it seems likely there will be significant speed bumps to a higher stock market without a much stronger economy.