If you learn how to interpret the overall value of stocks by using the P/E ratio on the S&P 500 Index, you can gain insights into the future direction of equity prices.
How to Interpret the Historical Average P/E for the S&P 500 Index
Although this is not a consistently accurate means of predicting short-term stock market fluctuations, the price-earnings ratio, also known simply as the "P/E," of the S&P 500 Index, can be used as a general barometer for determining if stocks may be overbought or oversold.
For reference, the average P/E ratio for stocks since the 1870's has been about 15.00. This means that, if you take the average price of the large-cap stocks in the S&P 500 Index and divide that collective price by the respective mean earnings, you get the P/E for what most investors call "the market." If this P/E is significantly higher than 15.00, it is reasonable to expect stock prices to fall at some point and if the P/E is lower, you can expect prices to rise.
Debunking the P/E: Why It Can Be a Deceptive Indicator
Now for some perspective, valuations for stocks can swing far away from the 15.00 P/E average. In fact, the P/E often lags economic reality. For example, according to advisorperspectives.com, "In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out." Earnings fell faster than prices. The P/E is a ratio (price divided by earnings). Therefore, if the earnings (the denominator) fall faster than prices (the numerator), the P/E can be deceptively high and thus make the P/E an inconsistent or perhaps a lagging indicator.
In summary, a P/E above 15.00 on the S&P 500 Index does not indicate a sell signal, nor does a P/E below that historical average indicate a sell signal. However, a prudent investor can use the S&P's P/E as one of many measures of health for the stock market. The conventional P/E looks back at the trailing twelve months or "TTM" and we know that the past is not a guarantee of future performance. Fundamentally, stock prices are a reflection of expectations about the future but also reflect the demand for equities as assets. For example, in the early 2010's, bond yields were falling and US Treasury Bonds were paying near zero interest and investors who were looking for income began buying dividend-paying stocks and dividend mutual funds. Furthermore, the distance in time from the horrors of the 2008 market decline steadily gave investors confidence to re-enter stocks even as prices on indexes, such as the Dow Jones Industrial Average, reached record levels in early 2013, when the S&P 500 P/E was still at, you guessed it, the historical average of 15.00.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.