The Price Earnings Ratio

The price to earnings ratio on the S&P 500 is currently sitting at about 16, roughly equal to its long-term average. This means that investors are paying $16 dollars for every $1 of profits earned by companies in the index. To put this in perspective, the P/E ratio prior to the 1929 stock market crash was about 28. Prior to the dot-com crash in 2000, the S&P traded at an all-time high P/E of 42.

This doesn't mean the market can't go down. It simply means that by historical standards, the market is not the house of cards that some analysts would have you believe. Earnings would have to remain flat while stock prices dropped 40% before we see, for example, a P/E of 10. This type of market valuation hasn't been seen since inflationary pressures clobbered the economy in the 1970's (before being reigned in by Fed Chairman Paul Volcker in the early 1980's). Unless we see the return of the Misery Index (Unemployment + Inflation) on the front pages of the Wall Street Journal, I don't see a P/E of 10 arriving anytime soon.