P/E Values May Not Be Cheap: Graham & Dodd Way

One of the big question marks for those like me who think the markets are overvalued is the seemingly low P/E ratio on stocks. Right now the P/E on S&P 500 is around 16. This is not expensive so why be cautious (bearish)? Well, one view is given by Marc Faber, who implied that there isn't a valuation bubble but there is an earnings bubble. If the 'E' part of the equation is "bubbly" then the P/E ratio will be low. That is a view that can be proven in hindsight (we just don't know if earnings are sustainable or not). How about P/E ratios from a historical point of view?

I came across a very good article in the New York Times by David Leonhardt talking about measuring long-term P/E ratios. Graham & Dodd suggested that one should use a long-term P/E ratio to look at valuation. Instead of simply looking at one year's P/E ratio, a 10 year ratio would be better. Here is a chart of what the trailing 10 year P/E ratios produce:



(source: Remembering a Classic Investing Theory By DAVID LEONHARDT, Published: August 15, 2007)

If you look at the trailing 10 year P/E ratios, the valuations don't seem low.

Based on average profits over the last 10 years, the P/E ratio has been hovering around 27 recently. That’s higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.

None of this means that a collapse is imminent, but it does imply that a correction is likely or that future returns are likely to be low.