The ABCs of P/Es

The Texas Monthly Biz Index—a market-capitalization-weighted index tracking the approximately 650 publicly traded companies headquartered in Texas—is currently trading at an average price-to-earnings ratio of 34.3 to 1. Is this a cause for concern? With stocks such as Dell Computer and Texas Instruments at P/Es of 65 and 71, respectively, many investors are concerned about a market fall.

They shouldn’t be. Judging by the history of the Standard and Poor’s 500 and, before that, the Cowles Commission Index, high P/E markets are nothing to fear. In fact, over the past 127 years, markets with P/Es above nineteen have higher annualized returns, lower annualized standard deviations (that is, risk), and a lower frequency of negative returns over the next one, two, and three years than those with P/Es below nineteen.

The two causes for high P/Es are eroding earnings (typically during or coming out of a recession) or high stock prices (based on strong earnings growth). The current market fits the second description: The companies in the S&P 500 have consistently exceeded earnings expectations for the past six years. Put another way, analysts have consistently underestimated earnings growth, resulting in regular surprises. This will continue until the P/E multiple falls back to between 10 and 19. At that point, market risk increases dramatically; all of the S&P 500’s double-digit declines have occurred within this range.

So don’t fear high P/Es. They’re a sign that we’re in a low-risk investing environment, and they should continue to provide healthy returns for at least the next year.

Data Sources: Cowles Commission 1871-1925, Standard and Poor’s 1926-1998, Thomson Financial