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How The Price Earnings Ratio Can Fool You at Trader’s Narrative

Last Friday we looked at the unprecedented earnings collapse that has fueled this bear market. The chart below is the flip side, showing the impact on the S&P 500’s valuation through the Price/Earnings ratio:

PE ratio long term chart chart of the day
Source: Chart of the Day

While the P/E ratio is a familiar rule of thumb that helps us to calculate the relative value of the stock market, like any metric it has a handicap. Looking at the chart, it is clear what that is for the PE ratio. Just imagine how ridiculously meaningless the ratio would be if we actually see negative earnings as many are predicting we will, for the first time ever!

But there’s no reason to panic, running out into the street screaming at the top of your lungs. The fact that the S&P 500’s price earnings ratio is 122.45 right now, once again proves that the price dividend ratio is a superior measure to price earnings. Dividends are a much better way of measuring value because unlike earnings, they are not prone to creative accounting and are considered sacrosanct.

While the P/E ratio is finding irrelevance in the stratosphere, the price dividend ratio is 38.6 - click previous link to see a historical chart of the price dividend ratio. And click this following link to see a chart of the price earnings ratio before the silliness began.

As S&P 500 earnings have collapsed from $62.28 - a year ago - to the present’s miserly $7.21, dividends have been much more robust. Dividends were $28.93 in May 2008 and currently they are $22.87 - a fall of just 21%. The Dow Jones Industrial dividend has fallen even less, 3.6%.

In the end, this is why we use many different methods to measure and analyse the market. Sooner or later, any one of them will go bonkers and provide useless output. At that point, it is important to realize that and not follow it over the ledge like lemmings.

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2 Responses to “How The Price Earnings Ratio Can Fool You”  

  1. 1 hugo

    Well, Im with you about is more interesting the dividend yield, but also is strange that the dividend remains strengh while the earnings fall a lot. DonĀ“t make sense to have losses and pay dividend. At least in my lineal way of thinking.

    Anyway, have you checked those spikes in the PE?

    All were tops in markets ready to fall.

    1946,1961,1987,1991,1999 were all time record in the indexes (except 1946 cause was lower than 1929).

    Of those 1991,1999 basically was being traded flat or slightly above in the next 12 months. But 1946,1961,1987 spikes are precedents of sharp declines.

    Also you will find that those spikes in that chart represents the market in 1938 and 2002. These two cases were not all times records, but rallies after bear markets. And nowadays maybe this is the case.

    Just go to S&P, take the exactly data of the spikes and then go to the market in those times.

  2. 2 dax

    To ignore PE ratios at this point of a supposed recovery is naive….history shows that initial “bounces” are sustained by one time inventory recovery and in this case, government backing….and your theory I guess, is that companies will grow into the earnings.

    Unfortunately, these “earnings” may not be coming back this year or for a while.

    our economy has suffered a unique hit to its base case -which was, consumption at any cost, with record levels of debt and lots of leverage to support it all.

    De-leveraging takes time to allow the unwinding.

    Prices ran up not on fundamentals (PE, dividends p/b) but on fear…Professional money managers fear of being left behind - and then being fires as a result….nobody likes being unemployed

    Thus PE ratios in this case are telling us a clue

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