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Why a higher P/E ratio for the market could lead to higher returns

The straight P/E ratio is a poor forecasting tool when applied to the stock market.

Even the ten-year cyclically-adjusted P/E ratio isn’t much cop, although it’s probably the best of a poor bunch of crystal balls should we be silly enough to try to outwit the market. (Reminder: Such guesswork is decidedly optional, especially for passive investors!)

There is an exception to the bit-of-a-crap-shoot principle, though.

Developed markets on very low P/E ratios have nearly always been amazing buying opportunities. If the P/E of the stock market ever again falls below 8, I’d buy all you can. Then sell your grandmother and buy some more.

The reason for the juicy returns are pretty obvious – on a P/E ratio of less than 8, the market is pricing in cataclysm. So far the worst hasn’t happened to Western markets, so anyone who was brave enough to buy when shares were at such bargain basement levels has been well rewarded.

Remember some markets don’t make it. The Russian and Chinese stock markets in the early 20th Century went to zero! If they passed through a P/E of 10, 8, or 2 on the way down it didn’t make any difference – you still lost all your money. There is always a risk of something similarly awful happening in the future, and that risk is essentially what buys your returns.

Absent a communist revolution though, a very low P/E ratio buys you a huge margin of safety, and a lot of future earnings on the cheap.

The stock market valuation bull’s eye

More interesting – and maybe more surprising – is what happens with returns when you buy above the “a P/E of what? Is that a misprint?!” range. These higher P/E ratios are a matter of practical importance, because you’ll far more often see a market on a P/E in double-digits than on a P/E of <8.

In fact, if you only invest in the market when P/E ratios are at the bottom of the barrel, you could be waiting for decades to strike – and depending on your selling rules you could be out again within a year.

Most of the time you’ll need to pay higher P/E multiples for your ongoing equity fix and the superior returns that shares can deliver. But how much is too much?

The following graphic from City Research sheds some light with respect to the S&P 500 index of leading US shares:

The higher the average returns, the closer the P/E band to the bullseye!

The higher the average returns, the closer the P/E band to the bulls eye!

Source: Business Insider

This graphic ranks P/E bands based on the average subsequent 12-month returns since 1940. Citi Research’s Tobias Levkovich crunched 73 years worth of S&P 500 returns data to produce it, dividing returns into bands by P/E rating1, and putting the higher performing bands closer to the bulls eye.

Remember: The Vanguard research I linked to at the top of this post showed P/Es have a poor record of forecasting market returns. I highlight this data to show that very cheap is good, and very expensive (a P/E above 20x) has been poisonous. It’s also useful to see that, as I speculate below, low to mid-teen P/E ratios have not historically been a reason to bail out of stocks. But don’t mistake this for a solid prediction machine. (There isn’t one).

Looking at the dartboard, as you’d expect from my comments, very low P/E ratios are associated with the highest average returns the following year.

With a P/E below 8, you’re paying less than $8 for every $1 of earnings (for an earnings yield of 12.5%). When you buy the market at such fire sale prices, there’s a strong chance that good things will happen!

It’s a bit different with individual companies. A company on a low P/E ratio might well be correctly priced because its business is in difficulties, or because its profits will never grow much. Sometimes that’s not the case – that’s why the value premium exists – but pretty often it is, which is why we’re not all millionaires from simply buying low P/E shares.

A P/E of 8x or less for the whole market is another kind of animal. Here you’re buying a slice of all the earnings of all the companies. Your investment will be driven by the largest companies, sure, but you’re still getting a lot of diversification, and lots of companies that will recover, as well as the deadbeats.

For that reason, I’d argue a low P/E market is a very different bet to a single company on a lowly P/E rating, and a much surer indication of value.

Stock market returns by P/E ratio

What’s also interesting about the dartboard is that outside of the bulls eye, the next band in the dartboard is not the 8-10x band, but rather the 14-16x band.

Of course this could just be a reflection of what the Vanguard study found – that you can’t learn much from P/E ratios.

But I can’t help wondering if it reveals a little bit more?

By implication, markets sporting P/Es in the 8-10x range proved, with hindsight, on average more expensive buys, whereas the 14-16x band was on a short-term basis a solid buy.

In fact, the 12-month returns for the 14-16x band were better than the entire range from P/E 8-14, as you can see in the data below:

P/E range Average Median
<8x 18.6% 18.8%
8-10x 8.9% 6.7%
10-12x 9.7% 9.6%
12-14x 11.2% 13.4%
14-16x 12.6% 14.6%
16-18x 5.4% 9.1%
18-20x 5.9% 6.5%
>20x -.43% 4.43%

Source: Citi Research / Business Insider

Once the P/E ratio gets above the 8 threshold, median returns for the S&P 500 over the next 12 months creep higher and higher, but they don’t peak until the 14-16x range.

Above 16x they swiftly collapse again, on a median return basis. And if anyone ever calls the market a screaming buy on a P/E of over 20x, scream back at them. (And keep your money away!)

Reassuringly expensive

What gives? Is this random, or can we speculate about why the more expensive P/E ratios are delivering higher 12-month median returns?

Very possibly not. Even 70 years of returns only encompasses a few market cycles, and the stock market constantly reacts and changes, too. It might have been luck that the data fell this way, and even if it wasn’t that’s no guarantee it will hold in the future.

Remember too that these are averages and median figures. They will conceal big variations, including negative periods of returns where shares were in the dumpster for the following 12 months.

One thing it does tell us is to be wary of people who warn of imminent crashes just because the P/E ratio has gone up from a lower level.

Looking at the data, a higher P/E ratio has been associated with higher median returns all the way from 8-16x. The data doesn’t necessarily imply any inevitable smooth rise like that – but I do think it’s one in the eye for the doomsters who claim markets are expensive just because they’ve bounced off their lowest levels, especially with interest rates so low.

Finally, if I put my speculation hat on, I think it’s a good reminder that cheapness isn’t the whole story.

I’d hazard a guess that P/E ratios of 14-16x are associated mostly with expansionary phases for economies. At such times, people are getting more confident and bidding up shares – remember, the market discounts the future, not the past – but not yet to crazy bubble levels.

Because stock markets climb slowly but jump off a cliff on the way back down, I doubt the market spends much time in the giddy 14-16x band unless the news is at least fairly optimistic.

To return to the individual shares analogy, paying a P/E of 14-16x for the market is the equivalent of stock pickers who look for Growth At A Reasonable Price (or GARP for short).

GARP investors want to see further expansion and higher profits ahead. They don’t want to pay through the nose for it, because they believe very high rates of growth are not typically sustainable for long enough to make up for paying a very high multiple on purchase. But modestly high P/E ratings are a positive with the GARP methodology, since it indicates the expectation of higher earnings.

It comes down to the ‘E’ part of the ratio – the earnings. Higher earnings will bring a P/E ratio down – or hold it steady – just as surely as lower prices (the P) part will. So if you think earnings will rise, you might bid up for them in advance.

People are far more obsessed with fluctuating share prices than with the prospects for underlying earnings, so they often forget this.

P/E is not a prediction

Remember that as well as being extremely difficult, valuation isn’t the same as forecasting.

One weakness in this study, to my eyes, is that the subsequent returns are just tracked for a year. Most of us should be investing with a far longer time horizon if we’re in shares. A 12-month period of slightly lower returns doesn’t matter if it means we’re all set when things pick up after that.

As always, I think most people are best off ignoring all this and investing passively. But for those who do want to flex their inner Master of the Universe, I think valuation – as in not paying over the odds – is a better path, and a better use of this sort of data – than trying to forecast short-term returns.

Some may say I’m quibbling over semantics and it amounts to the same thing, but I think the mindset is different: I believe an active strategy based on trying to get a good deal when you buy is one that will serve you better than a strategy that tries to guess what the deal will be in a year.

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  1. I am 99% sure this data is based on forward P/E ratios, which is to say it’s looking at how the market is priced based on analysts forecasts (and some won’t like it for that reason). If anyone has access to the Citi Research directly and can confirm in the comments, please do! []
{ 24 comments… add one }
  • 1 John @ UK Value Investor September 20, 2013, 11:41 am

    So what I can draw from that neat bulls-eye is that extreme valuations are strong indicators of future returns, while all the valuations in the middle are a mixed bag and not very predictive. That’s kind of what I’d expect.

    I think the Smithers “valuing wall st” approach of using PE10 or Tobin’s Q, plus looking at forward returns over 1 – 30 years is a better way of doing it.

    But the basic idea remains intact. Overpay and you’re more likely to underperform… underpay and out-performance could be on the cards.

  • 2 Rob September 20, 2013, 11:42 am

    Remember that reported earnings are the highest figure the board thinks the auditors will allow. Next year’s board might change them.

  • 3 The Investor September 20, 2013, 11:55 am

    @John — I agree, the extremes are the only solid takeaway I reckon. Personally I think Tobin’s Q is a bit dated in the intellectual property era. As for PE10, yes it’s the best of the bunch, but as you’ll see in the Vanguard research recap I link to it isn’t perfect. Bottom line for me if you’re an active investor is to stick to your strategy unless the market is very elevated/depressed, and probably only change your relative weightings (especially towards fixed income versus equities) rather than wholesale even then.

    @Rob — You old cynic. 😉 If you can work up a similar bull’s eye based on reported dividends, I’d be happy to look at it. Appreciate this isn’t really your wheelhouse though.

  • 4 Greg September 20, 2013, 12:02 pm

    I wonder if there is any difference if some sort of directionality is applied. i.e. splitting P/E of 10-12 when the previous valuation band was 8-10 from when the previous band was 12-14.

  • 5 rjack (Mr. Asset Allocation) September 20, 2013, 12:13 pm

    I think PE10 works better and I use it as a mechanism to incrementally add or reduce my equity percentage based on its level.

  • 6 dearieme September 20, 2013, 12:35 pm

    “This graphic ranks P/E bands based on the average subsequent 12-month returns since 1940.” I expect my wife to survive me by about 25 years, so I’m not much interested in the “subsequent 12-month returns”.

  • 7 The Investor September 20, 2013, 1:10 pm

    @Greg — I wondered about that too. The problem is you have two moving parts. Earnings will fall at some point in a recession, which will elevate P/Es, which is where so many amateur speculators go wrong each cycle. (“It’s a recession yet the market is on a P/E of 18!” or what have you). You’d have to unpick hindsight bias, too. (You don’t know the market is going up until it stops going down, so directionally might require some judgement calls, especially with volatility). Personally I wouldn’t push it beyond more than a reinforcement of the limited use of current P/E ratios for the market.

    @dearime — The correct attitude, IMHO. That said if you had a forecasting tool that actually did predict 12-month returns, then even a long-term investor would be nuts not to use it. A perfect short-term market timing tool would turn any one of us multi-millionaires. Which is the big clue as to why it doesn’t exist!

    @rjack — That’s probably the best use of PE10, as long as you recognize it has limitations, too, as I link to. (So even as an active investor I wouldn’t, say, reduce below some equity threshold, whatever PE10 was telling me. And for the record it’s been a truly awful guide to most of the stock market recovery of the past few years, mainly because of the ‘E’ part).

  • 8 Geo September 20, 2013, 1:41 pm

    Interesting…. anywhere one can easily find PE or PE10 ratios for world markets? E.g UK, Europe, Japan, Emerging Markets, Pacific and the US?

  • 9 Paul Claireaux September 20, 2013, 1:42 pm

    Hi guys,
    I like CAPE – which is readily available from Prof Shiller’s site.
    Mebane Faber (a portfolio manager) has produced an interesting note on CAPE called ‘Global value: Building trading models with the 10 year CAPE’, and you can also obtain updates to a worldwide list of CAPEs – offering clues as to which geographical markets are overheated and which have cooled off – at http://www.mebanefaber.com/2013/04/01/cape-updates
    Currently it appears that the UK is neither hot nor cold, but that the US is quite overheated.
    Do you know where can we access that Tobin’s Q data?

  • 10 BeatTheSeasons September 20, 2013, 1:47 pm

    If a company has a bad year then they’re going to write down every possible dubious asset value they can find, own up to all the dodgy stuff they were previously claiming could be justified staying on the balance sheet, accrue the maximum, maybe announce some restructuring before year end so they can provide for it in that year, etc, etc. Purely because they’ve already stuffed up so they might as well stuff up a bit more and make sure all the skeletons have been cleared out of the cupboards before next year.

    Assuming the bad year was a one-off, that’s going to flatter the following year’s results, which could provide an explanation for the ‘bounce’ in results for companies with low P/E ratios.

  • 11 Paul Claireaux September 20, 2013, 2:07 pm

    Just noticed that the link I’ve provided above offers only April 2013 updates. Have mailed Mebane Faber for guidance on where to find more recent data – hoping it’s not a paid for service.

  • 12 The Investor September 20, 2013, 2:44 pm

    Every time I write about valuing the market, supporters of PE10 come out and blow the trumpet. I say again, PE10 would have kept you out of most of the market rally (it briefly blink-and-you-missed-it signaled a buy in the March 2009 lows, from memory) so it’s been a horrendous timing mechanism at least to date (perhaps markets will plummet and justify missing out on 70-100% gains, but I doubt it).

    And that Vanguard research pointed to an only reasonable correlation with PE10 and ten-year returns — better than the rest but not a slam dunk.

    Each to their own, and I am certainly always curious about the PE10 data — I think I posted than Mebane Faber research here earlier this year 🙂 — but I’d never run a mechanical strategy on PE10 and I wouldn’t want a casual reader to think they’re missing out on some sure route to outperformance, because it’s really not.

    e.g. See the graph on page one of this research: http://www.aqr.com/Portals/1/ResearchPapers/ShillerPECommentary_AQRCliffAsness.pdf

    PE10 gave you one clear buying opportunity between 1990 and today, and any true PE10 believer probably would have started selling very soon after they bought and the PE10 ratio climbed high above the average once more.

    I say again, I’m not dismissing it as another piece of the picture, and I certainly like to think I’d have paid attention in 1999/2000. But to be honest I think people like it because it’s simple, not because it works. 🙂

    But everyone is entitled to their own view.

  • 13 Paul Claireaux September 20, 2013, 4:12 pm

    To the investor.
    Hmmn – I tend to think people are NOT right or entitled to a view if it’s nonsense but we can agree to disagree on that perhaps.
    I think you’re right to say that no system works with any accuracy over short timescales. So it’s curious that you choose citibank data based upon subsequent one year returns! Ho hum.
    The point about CAPE is that it highlights the times when valuations have gone mad – like 1998 onwards.
    The recent rally – i think most reasonable people would agree – has little or nothing to do with valuations (which are stretched – most certainly in the USA) but a great deal to do with central bank manipulation of the allegedly risk free rates in government bonds.
    October could be interesting as the Americans bang their heads against another debt ceiling.

  • 14 The Investor September 20, 2013, 4:56 pm

    I am choosing the Citi data to show that middling P/E levels are not a reason to get out of shares or fear inevitably poor returns. I’d hoped I’d made that clear in the article. 🙂

    In the comments people are saying they are using PE10 for much more than that, to the extent it’s a major determinant of their asset allocation strategy. That’s what I’m warning against.

    PE10 is championed by smart professor Bob Schiller so I’d be arrogant to call it “nonsense”. But as a practical one-shot allocation tool, I don’t see it. 🙂

    P.S. I must be unreasonable because I think current valuations gave everything to do with economic conditions, of which the Fed is just one part. But then I don’t use a timing system that would have had me in the market for barely one month of the massive bull market… 🙂

  • 15 Paul Claireaux September 20, 2013, 5:07 pm

    And i guess we also agree that bombed out PEs – might just mean we’re on our way to communism!
    Indeed – when you look back i reckon we came close to it in the early 1970s here!
    Any pointers to the history around investor losses when businesses become nationalised – here or in Russia etc – gratefully received.


  • 16 The Investor September 20, 2013, 5:13 pm

    @Paul — Viva la international diversification! 😉 Preferably including some offshore assets.

  • 17 Mike September 20, 2013, 8:36 pm

    A great read.
    I wonder what the P/E value of the Indian market is after their recent falls ?

  • 18 Paul Claireaux September 20, 2013, 10:17 pm

    CAPE on India at end of August was 17.7 and it’s climbed since.
    At same time the CAPE on Ireland was 6, Italy was 7.32 and UK 13.36.
    USA was 24 !!
    Only Philippines, Columbia and Sri Lanka were higher.
    Watch out below.
    Question is how long can Bernanke and his successor keep gravity switched off.

  • 19 Rob September 21, 2013, 9:13 am


    I have two quibbles with valuing companies. One is that the that individual stocks are far too risky. But valuing the market as a whole is even more difficult. The second is that the bulk of equity returns come from dividends, not capital growth.

    But you knew that is my view anyway.


  • 20 John Law September 21, 2013, 6:51 pm

    Agree with Paul.

    Why try applying fundamental analysis to manipulated markets? How can you claim equities are priced correctly when the price of money (along with everything else) is egregiously manipulated?

    All manipulations fail eventually. When they do, watch out below.

  • 21 The Investor September 22, 2013, 10:36 pm

    @All — The other reason I don’t talk about macro stuff much is because as soon as you do on the Internet, this kind of doomster comment stuff starts to appear — “manipulated markets” built on “thin air” — and one either has to spend hours debunking it with each new article, or one has to delete it, which doesn’t sit well with me but I would do if I wrote about macro a lot, because I wouldn’t want to have created another doomster portal by accident.

    Seriously chaps, each to their own, but if you really think we’re just living in some fictitious manipulated market where nothing can be trusted and it’s all a grand Ponzi scheme pulled off by the Fed, then I wouldn’t have thought Monevator is the site for you and I wonder what you get out of commenting on it? It’s not like there’s a shortage of places to pow-wow with your fellow Fiat-money hating Fed bashers. Head to Zero Hedge. Or even The Telegraph.

    This site is aimed at the quiet majority of reasonable people.

    Here’s why the Fed is printing money, in simple terms. There was an enormous destruction of value created by the financial crisis. On this we all agree, except to the extent that doomsters and I differ on how much of the destroyed value was “real” anyway (a curious contradiction in the doomster creed, actually — when was year zero? Do they trust nothing since 1971 and the US leaving the gold standard, perhaps? Think you’ve seen an iPhone or the computing/Internet revolution or most people owning two cars and a dishwasher or China pulling itself out of mass poverty or any of the other achievements of capitalism since then? Nonsense, fools! None of it is real! It’s all a fiction!).

    Back to now: the financial crisis damaged both solvency and liquidity throughout the system. In the face of this, the Central Banks could either allow the financial system to fold, unemployment to soar to 1930s levels, etc, or they could do what they ALWAYS do which is pour liquidity into the system to essentially calm the system, stem the rout, by bringing down rates as far as they can, through whatever means necessary.

    As they do so they stop NOT the rampant enthusiasm that doomsters somehow see in a stock market barely getting back to where it was a decade ago in nominal terms, but rather to address the rampant bearishness that in reality drove real interest rates below zero as even institutions became so fearful and bearish and terrified that they were willing to pay banks or the government to hold their money.

    Eventually these extraordinary moves will be reversed. The reversals will be clumsy, because it’s hard stuff. It’s not magic. In my view we will likely pay through it with some combination of (1) higher inflation than would otherwise be the case (2) less efficient businesses (because some were kept alive that should have died in an ideal world) (3) wealth transfers (currently from future productive workers to today’s owners of assets) (4) lower real median incomes.

    That’s the price of not repeating the 1930s in a modern democracy. I don’t blame them for taking it.

    Readers who take too much of this doomster comment seriously might at least ensure they read investing literature from the 1930s, 1950s, 1970s and so on, and understand that this nihilistic vein is nothing new or novel. Believe it if you like, but don’t believe we’re living in some special time that suddenly warrants it.

    Rather, the unbelievers are always with us.

    It’s quite amusing actually reading The Snowball, the Warren Buffett biography. The very young Buffett sits every Saturday morning with his two aged great-uncles, one of who is a perma-bull and the other is a perma-bear who believes US Steel etc is going to zero because of the irresponsibility and recklessness of the US state etc. (Sounds familiar? This is from 80 years ago, and not coincidentally after a major market crash…)

    Later on Buffett’s own stockbroking father champions various gold related causes and promotes the adoption of farmland and other real assets as protection against the coming economic cataclysm.

    Meanwhile only one of them — Warren Buffet — becomes the richest man in the world by not taking it very seriously.

    Sure, there’s a few modicums of truth in the doomster diatribe. All financial systems are unstable, and periodically participants forget this. Systemic crisis is always possible. Perhaps hold 5-10% in gold and other hard assets if you like, preferably including some offshore.

    But go beyond that at your peril. The odds are entirely against you, IMHO.

  • 22 Paul Claireaux September 22, 2013, 11:06 pm

    To the investor.
    This is your site so I’ll leave as requested.
    But before i go – For the record
    I am a quiet, reasonable person myself also as I suspect are others who you class as doomsayers.
    With a passion for good science and engineering I too appreciate that technology is the primary force behind rising living standards.
    But I also recognise that when debt has risen too far there is inevitably a pause in activity. Perhaps central backs will keep it at that – and hold things steady whilst inflation erodes the debt.
    Or perhaps the correction will be quicker and more severe after all we have inflation but real earnings are now going backwards.
    Who knows hiw this debt crisis will play out? None of us.
    Who does it concern? Different people to very different degrees depending upon whether they’re starting out on a savings journey or they’re at the end and looking to preserve capital. It seems that your messages are aimed more at the younger generation – to whom a 40% trough in the road would be good news because of improved prices.
    Quite different for those of us at or nearing the withdrawal phase.
    I wish you well with your blog and apologise if the challenges caused too much disturbance.
    I’ll be leaving now – and I might be some time !

  • 23 The Investor September 22, 2013, 11:15 pm

    @Paul — Fair enough, and cheers. You should get your own site up and running (it’s been TBC for a while now?) If you do then feel free to alert me to any links to any new articles you write that you think suitable for our readership (in the light of our conversation above and others! 🙂 i.e. More advice/practical based) and I’d be happy to consider giving it a plug in Weekend Reading if applicable. All the best!

  • 24 Paul Claireaux September 22, 2013, 11:22 pm

    Yes, the site will be up in the next few weeks as will my first book
    ‘who can you trust about money’
    (how the experts mislead us and how we mislead ourselves)

    Will keep you posted.


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