One valued and fundamental measurement of stocks (and, ultimately, the entire stock market) is the Price Earnings Ratio or PE Ratio. Simply speaking, the PE Ratio is a measure of how expensive any given stock or basket of stocks are relative to their earnings or earnings power.
To establish the PE Ratio is fairly simple. It is calculated by dividing the current stock price by the last known or even the projected per-share earnings of any given stock or basket of stocks. The result is sometimes referred to as the trading "multiple" and it reflects how high the price of the stock is in comparison to its earnings's power. Typically, high PE stocks are called growth stocks. This is because high PE ratios reflect some speculation on the long-term growth prospects for that stock.
Other than baseball and football, no other activity has so many accumulated statistics than the stock market. It is charted and measured; both six ways and sideways. But a simple way to look at the stock market as a whole is to look at the average PE Ratio for any given market basket of stocks. A market basket might be all financial stocks. Another could be all auto stocks. But, generally speaking, the most common market basket of stocks -- the ones that most people are aware of -- are indexes like the Dow Jones Industrial Average and the S&P 500.
Most seasoned investors look to the Standard and Poors 500 basket of stocks because it is more broadly accurate than the other and more widely popular measurement of the stock market: the Dow Jones Industrial Average.
At the end of 2007 -- just before the recession -- the average PE Ratio for all the S&P 500 stocks was 22.19. At 22.19, that multiple was even higher than normal; indicating that the stock market was severely overbought and was due for a correction. Since then, the stock market had taken a 50+ percent tumble to a low in March of this year. By March of 2009, the average PE Ratio for the S&P 500 went to a whopping 116.31; or, about 5 times higher than it was in December 2007. Remember, if 22.19 was a high number in 2007, then, 116.31 in March of this year was even more ridiculous; indicating an absolutely overpriced stock market.
Yet, despite that fact, the stock market has rallied back from the March lows of 667 on the S&P 500 to today's level of near 1071. That's a percentage gain of over 50%. Simply looking at this fact, one might conclude that the earnings of all those stocks that make up the SP-500 would have to have increased by 50% or more. However, the reality is that the corporate earnings continued to fall. That's why the current PE ratio is close to 141; or, over 6 times of what it was in December of 2007.
So, what is the conclusion here?
The conclusion, to me, is that we are in another bubble. This time it's the stock market; and, not housing. There is absolutely no reason for this stock market to have climbed as high as it has; in such a short period of time; and, without any earnings to support it. There is absolutely no prospect for earnings to increase substantially in the short term. And, no reason that would support the kind of market movement that we have seen since March. If anything, the stock market should have fallen even farther after hitting the March low. Therefore, this should give pause to anyone who is now invested in the stock market. I am concerned that we are due for another fall in the not too distant future.
(Click to View a 5-year Chart of PE Ratios for the S&P 500)