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Market Realist Chronicles: Protect your investments from a stock market bubble

Part 2
Market Realist Chronicles: Protect your investments from a stock market bubble (Part 2 of 5)

Is the price-to-earnings ratio really that useful?

Is the price-to-earnings ratio all it’s cracked up to be?

To understand whether a market is cheap or expensive, you’ll typically turn to the price-to-earnings ratio. This tells you how much you’re paying for a company’s earnings.

For instance, if a company is earning $1 per share and its stock is trading at $20, then you’re paying 20x earnings for that stock.

However, that doesn’t tell you much. It doesn’t tell you if that’s cheap or expensive. It doesn’t tell you if you should be invested or back away from the stock.

I’ve found that you can understand the outlook better by flipping the ratio around. In other words, look at the earnings-to-price ratio, or the earnings yield, instead.

Stock market earnings yield vs 10 year Treasury yield 2014-07-09Enlarge Graph

You can think of the earnings yield as the yield on a bond. It’s based in percentage terms—like a bond yield. This gives you an apples-to-apples way to compare returns across asset classes.

What is the earnings yield telling us now?

The market is currently trading at a price-to-earnings ratio of 18.1x. This implies a 5.5% (1/18.1) earnings yield on stock investments if both prices and past earnings remained constant.

To put that in perspective, let’s take a look at some historical earnings yields.

The last time the S&P500 (SPY) reached a 5.5% earnings yield was in June 2011. The higher the market goes, the lower the yield since you’re paying more for the same earnings.

And in the aftermath of the ~50% drop we experienced from September 2008 to March 2009, the market hit an earnings yield of 9.1%. This was a high yield, meaning it was cheap. Who wouldn’t want an investment with a return close to 10%? As the market rebounded, the earnings yield dropped to 4%.

During the dot com boom, the market had an earnings yield of just 3.3%. At the time, the ten-year Treasury bond (IEF) was yielding close to 6.0%. In that scenario, would you have stayed in the stock market or simply move to the safety of the bond market and earn almost twice the yield?

Keep in mind, though, that this metric is useful over long investment horizons. It’s not a metric for short-term changes to a portfolio.

In the next part of this series, I’ll summarize what the market may be telling us now and outline important details you shouldn’t overlook.

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