Over time, the price that a stock, or basket of stocks, trades at relative to its earnings provides a barometer of value.
Going back to 1870, a price-to-earnings ratio between five and 10 was low and generally meant stocks were priced cheaply. 20 to 25 is high and means stocks are priced at a premium relative to historical norms.
The current P/E is 28.4. In the last 150 years, there have only been a handful of times when the P/E of the S&P 500* has gotten higher than it is now.
- The “dotcom” rally and crash between 1998 and 2001
- The financial crisis of 2008 and 2009
- Following the Covid pandemic in 2020
Other than these events, the P/E ratio hasn’t been higher than it is now. This says stocks are priced extremely high but doesn’t necessarily indicate a crash is coming.
Cory Mitchell, an analyst with Tradequotex.com, said, “In 2001, 2009, and 2020 the P/E spiked beyond current levels after stock prices had already been in freefall for some time. The P/E spiked because the earnings of companies dropped faster than the stock prices.
“Think of the pandemic. Many stocks fell 20% to 30% very quickly and then recovered, but over the following months, many companies saw even larger declines in earnings. Some formerly profitable companies had negative earnings as demand for products dried up (cruise lines, restaurants, airlines, to name a few).
“This creates a situation where earnings are low, and prices are high, even though prices have fallen somewhat, creating a high P/E ratio. In 2009, the P/E hit astronomical levels because banks were failing and companies (earnings) were not performing well in the aftermath of the financial crisis. Stocks had already declined for more than a year and were already recovering by the time the P/E spiked.
It is the decline in earnings that generally causes the big spike in P/E ratios, but the stock decline was already underway. The exception is from 1998 to 2000; P/E was at similar levels to now before the crash occurred and earnings sank, resulting in even higher P/E levels. Prices are elevated now, but earnings haven’t significantly declined.”
The following chart shows the P/E ratio over time, courtesy of Multpl. When stock prices started to decline have also been marked on the chart, for the last 30 years.
*The S&P 500 hasn’t been around since 1870. It began in 1957, with the S&P 90 being introduced in 1928. Cowles Commission provides data further back. So historical data going back to 1870 is based on a relevant index or data source at the time.
What does the high P/E mean for stocks?
Are earnings inflated and sustainable? That is the real question investors need to be asking.
There is no doubt that stocks are priced extremely high in terms of historical norms right now, but that doesn’t mean prices will crash.
Prices could stagnate or increase a small amount while earnings increase by a greater amount. This would bring down the P/E ratio over time.
The P/E ratio could also stay high. Higher P/E ratios have been the norm over the last 30 years compared to the prior 100 years. The ratio is still high even based on that logic.
Many technology names are being driven by the AI craze. Companies are investing heavily in this technology which has helped providers of such technology or infrastructure, such as Nvidia (NVDA) and Super Micro Computer (SMCI), see monster price gains in their stocks. That is fine if earnings stay robust; if earnings decline P/E spikes and prices will already typically be on their way down.
The question remains whether the investment in AI technology will actually make companies more efficient and more profitable. This affects the companies using AI technology and providing it.
Conservative investors may wish to avoid going aggressively long here, at such a high valuation, but ride the momentum with current positions while it lasts. The risk is missing out on a continued rally, as prices can continue to increase even when P/E is high.
