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The price-earnings (P/E) ratio is a key metric in stock valuation. This indicator allows you to know if a stock is expensive or cheap compared to its history.
It is also used to project possible long-term returns.
However, when it comes to anticipating short-term market movements, its usefulness is questionable. TKer’s “Stock Market Truth #6” makes it clear: Valuations do not predict short-term price behavior.
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The current context: high P/E ratios
Currently, forward P/E ratios are at historically high levels.
The forward P/E of the S&P 500 index exceeds 22 times. This level raises concern because, on previous occasions, it preceded significant annual declines.
But there are also precedents in which high ratios translated into positive returns. This fact shows that, although the P/E ratio can provide clues about valuation, it does not guarantee a specific market direction.
Enthusiasm, not immediate risks
Schwab experts such as Liz Ann Sonders and Kevin Gordon say the current situation is due to increased enthusiasm for the stock. While they acknowledge that high multiples may seem concerning, they also note that this does not necessarily pose a risk to near-term performance.
In the SP500 graph, throughout this year 2024, we see the unstoppable growth in its price, reaching new historical highs in recent months.
According to analysts, multiples may continue to rise, as they did in the late 1990s. At that time, high multiples did not stop price increases. This point underscores that the relationship between ratings and performance is neither direct nor predictable.
P/E and performance: a weak correlation
Historical analysis shows that the relationship between the S&P 500’s forward P/E ratio and one-year performance is almost zero. Since the 1950s, this correlation has been at -0.11. This implies that there is no consistent relationship between the P/E level and the following year’s performance.
To illustrate this point, Sonders and Gordon mention two opposing cases. In one, a P/E of 25 preceded a drop of nearly 30%. In another, with the same P/E of 25, the market registered a rise of 45%.
These examples show the diversity of results that can occur from the same P/E level.
Key lessons for investors
The main learning for investors is that the P/E ratio should not be used as a market timing tool. Although it is useful for evaluating whether a stock or the market is expensive or cheap, its ability to predict short-term movements is practically nil.
History shows that even high P/E levels can precede strong rises. At the same time, moderate P/Es can be followed by significant declines.
The conclusion is clear: The P/E ratio is a valuation tool, not a prediction one.
What can investors do?
Instead of obsessing over the P/E level, investors should focus on more important factors such as the financial health of companies, global economic conditions and growth prospects.
Additionally, it is crucial to maintain a long-term perspective. Short-term volatility is inevitable, but the fundamentals of a well-managed company tend to prevail over time. Using the P/E as the sole reference for making investment decisions can lead to costly mistakes.
Conclusion
The price-earnings (P/E) ratio remains a relevant tool for evaluating valuations.
However, its usefulness in predicting the market is limited. History and current data confirm that there is no clear and direct relationship between P/E and short-term future returns.
Savvy investors should remember that while the P/E provides context, it should not be the sole basis for making investment decisions. The key is to look at multiple factors and take a long-term perspective, leaving aside the temptation to “predict” short-term movements.
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