Thursday, June 23, 2011

10-Year Normalized P/E Ratio (Part 2 of 3)

At any given point in time, figuring out how to interpret the P/E 10 may not be as straightforward as it seems. Figure 2 (below) plots the P/E 10 for the S&P 500 since 1880 to date. If we consider the historical average equal to 18.06 to be a normal or fair value for the P/E 10, then the most recent reading of 25.90 would indicate a 43.40% overvaluation. If instead we were to use the historical median, currently equal to 15.85, the S&P 500 would appear to be 63.45% overvalued. Alternatively, if we wanted to consider how the most recent reading of 25.90 ranked within the historical sample, we would find that it corresponds approximately to the 90th percentile, where anything above the 50th percentile would be considered overvalued territory. Therefore, depending on whether we use the average, the median, or the percentile ranking, currently the S&P 500 would appear to be between 40% and 63.45% overvalued.

Notwithstanding a sizeable difference between these two numbers, certainly neither of them bode well for buy and hold investors entering the market at this point. However, this is only one way of looking at the problem. If we instead focused on the historical range of the P/E 10, we would notice that historically the P/E 10 was as low as 4.46 and as high as 48.94. The implied mid-range is 26.70, which is approximately 3% greater than 25.90, the most recent reading. Therefore, using this approach, currently the market would appear to be slightly undervalued.

The cause of the large discrepancy in the conclusions reached by the different methodologies is not a mystery: Figure 2 clearly shows that during the 2000 tech bubble the P/E 10 inflated to never-before-seen levels. If this once-in-a-century event is ignored, then the upper bound of the historical range would have been below 35, implying a mid-range of approximately 20 and consequently some degree of overvaluation in the most recent reading of 25.90.