Answering Nono’s Question

Just this morning, a reader posted this comment:

In 1999 I plotted the trailing PE ratio for the DJ30 back to 1925. I have not updated it. But a quick look at the graph shows the average to be close to 15. Only two periods, once for 3 years and once for 4 years, had PE ratios below 10. So I think you are wrong.

I also made a correlation plot of PE ratio vs. following year market performance. There was not a significant correlation. In other words, forget about PE ratio when trying to decide what the market will do in the next year.

Dear Nono,

I very well could be wrong in stating that the trailing PE ratio of the broad based American stock market is around 11, but I did not actually come to that figure. That is the figure that is being used by Bill Bonner, as well as an entire group of Economists that Henry Blodget follows. So, if I am wrong, I am at least part of an entire wrongheaded crowd. 🙂 

Seriously though, I’d encourage you to follow the link for the Blodget story and see if you can research the differences between your number and the 11 figure that is more commonly used. One noticeable difference would seem to be that you plotted the Dow Jones 30 whereas the others are looking at the far broader S&P500. Also, you stopped at the year 1999, which was the market top for PE as it turned out. If you go forward through the end of this year, I’m sure that would lower your average a bit. 

In regards to your claim that buying stocks at a lower PE does not impact the level of return you get, you are contradicting other economic study regarding stocks. In John Mauldin’s book Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market he specifically says that “, the long-term returns you get from index fund investing are very highly correlated with the P/E (price to earnings) ratio at the time you make your initial investment.”

So those are the sources I am using. I have not done the math myself, but if you point me in the right direction in terms of where I can get the dataset, I may run the numbers myself to see what I get.