The P/E Ratio and Stock Market Performance

The U.S, stock market entered 2000 with five consecutive years of exceptional gains. The S&P 500 index gained more than 18 percent each of these five years, and its value tripled since 1995.> Concern has arisen recently that the stock market may be headed for a downturn because firms' share prices have become very high relative to their earnings. Analysts who hold this view point out that, in the past, high price-earnings ratios have usually been followed by slow growth in stock prices. Other analysts argue that history is no longer a true guide because fundamental changes in the economy have made stocks more attractive to investors, justifying a higher price-earnings ratio.> Shen examines the historical relationship between price-earnings ratios and subsequent stock market performance and discusses why history might not repeat itself this time. She finds strong historical evidence that high price-earnings ratios have been followed by disappointing stock market performance in the short and long term. Specifically, high price-earnings ratios have been followed by slow long-run growth in stock prices. Moreover, when high price-earnings ratios have reduced the earnings yield on stocks relative to returns on other investments, short-run stock market performance has suffered as well. Despite this evidence, however, she concludes that we cannot rule out the possibility that these historical relationships are of little relevance today due to fundamental changes in the economy.