It is commonly accepted that the P/E (Price Earnings Ratio) is a key metric in evaluating the not only individual stocks but the valuation of the stock market as a whole.

P/E ratios for the US stock market are generally understood to reflect fair valuation when they range between 14 and 20.  Exactly where depends on many factors including interest rates and whether looking at current year, trailing 12-month or forward twelve months.

In checking the Wall Street Journal, I was surprised to see the market P/E, as measured by one widely followed index, to be 49.13.  That’s correct, the Dow Jones Index on Tuesday, February 8, 2008, reflected a P/E of 49.13 on the 30 Dow Jones average stocks.

Three quick generalizations:

-A single number in a headline may or may not be an accurate representation of the underlying structure it purports to measure.

-“Quant” or computer/mathematical investment models can yield unexpected results if an out of bounds measure affects a key statistic.  (Hypothetically, an automated investment program that took into account the P/E ration of the Dow Jones Average could yield unexpected results without adequate checks and balances.)

-Cross check unusual results for an explanation of apparently outlandish results.  (The P/E for the NASDAQ on the same date was 29.20; for the S&P 500 18.90.  These data are for “trailing 12 months” earnings.  The same ratios for “forward 12 months” earnings are 15.00 (Dow Jones Industrials; 21.45 (NASDAQ) and 14.60 (S&P500).

This statistical aberration also illustrates how unusual events in one part of the market can appear to affect thinking about valuation of the market as a whole.  Four of the 30 stocks in the Dow Jones Industrial Index are large bank, insurance and investment companies.  The multi-billion write-offs associated with the sub-prime mortgage crisis have an outsize effect on the value of the index itself.  The NASDAQ would show little effect from this as there are few banks in the index.  The S&P 500 would show the same general effect, but diluted as the banks posting these write-offs make up a smaller portion of overall index valuation.

Jack Carney

 

 

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