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Look at any stock quote, you'll see the price-to-earnings ratio. It's something that has been a permanent part of an investor's toolkit. But the ratio does have its flaws. For example, it does not look to the future; instead, it is based on the earnings for the past 12 months. Also, earnings can be a moving target, especially with acquisitions and restructuring charges. But according to a recent piece in the Wall Street Journal, the death knell for the PE ratio is apparently getting closer. This is especially the case for when the indicators is used to measure the overall valuation of the market, such as the Dow or S&P 500.
This seems ironic since the PE ratio is helpful for value investors. And as markets trend lower, this should be a good indicator, right?
But this does not seem to matter. Even as earnings continue to grow, the overall PE ratio is actually declining.
Why? First of all, investors are getting weary of the volatility. What's more, as fear deepens -- and there are are concerns of a prolonged economic slump -- investors have been putting their money into bonds.
Consider that over the past year, the PE ratio on the S&P 500 has gone from 23.1 to 14.9. It's the biggest fall since 2003.
OK, could this actually be a contrarian indicator? Is it now time to jump into the market? It could be. But it's important to realize that markets can remain undervalued for a long time, as was the case in the 1970s (when the PE ratio fell below 7). True, there will be occasional rallies, which can be large. But for the most part, investors need to be nimble when markets go through long phases of volatility.
Tom Taulli is also the author of several books, including the Complete M&A Handbook as well as the upcoming book, All About Short Selling.
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