If the ratio is low, some claim that a company’s stock valuation is “safe” and share prices are likely to rise. In contrast, if the ratio is high, they say share prices are likely to fall. That seems simple and intuitively sound doesn’t it? A nice simple idea like that always excites people. Other gurus decided to expand on it. They applied the idea to the broad indexes of stocks, coming up with a P/E ratio for the broad stock market, most often using the S&P 500. According to them, if the ratio of the S&P 500 is “dangerously high”, stock prices are “susceptible to a bear market.” Conversely, when ratios are low, they believe that the market will rise.
Unfortunately, it isn’t true.
The interest rate manipulations of a central bank are far more important than any other factor in a myriad of ways, even beyond the subject of stocks and economics. When people asked me how I knew that Donald Trump would be the next U.S. President a week before the election, for example, I answered by writing an article, and explaining that my insight came purely from observing gold price manipulation. If you want to learn how this works, read the novel “The Synod”.
At any rate, I made offhand mention of the fact that the Obama administration has helped create the biggest financial bubble in history. It triggered an unhappy comment from a stock-loving reader, who assumed I was talking about an impending crash in stock prices. I was actually talking about the bond market, which has a value several orders of magnitude larger than the stock market.
However, his comment raised some issues that beg clarification. The commenter insisted that stocks cannot crash because the S&P 500’s current P/E ratio is not historically high. At slightly over 25 to 1, he is wrong. It is historically high. It is simply not inside astronomical territory. But, it is a bit on the high side. History tells us that crashes don’t need to be preceded by astronomical P/E ratios.
Thankfully, for current stock investors, generally speaking, P/E ratios don’t matter much to future bull or bear trends. The ratio is most useful for evaluating the ability of a company to pay a dividend and for nothing else. That doesn’t mean stocks aren’t about to crash. It simply means that a modestly high or low P/E ratio has no predictive ability, whatsoever, when it comes to the future of stock prices. It never has. Never once! Just the opposite!
For example, the decline in stock prices at the beginning of the so-called “Great Recession” began in Fall of 2007. The S&P 500 P/E ratio was only a bit over 19 to 1! By January 2009, one year and four months later, stocks declined a lot. In spite of that, the P/E ratio had still risen to about 71! That’s when the fastest decline began (between January and mid-March 2009).
The key point is that the 71 to 1 ratio in January 2009 was not a result of rising stock values. It occurred because most investors fell behind the curve. They hadn’t dumped stocks vigorously enough to force prices down all the way yet. Earnings had simply fallen faster than stock prices, but stock prices were already in a bear market!
When the dot.com bubble started to burst, back in March, 2000, the S&P 500’s P/E ratio was a bit over 28 to 1. By August 2003, in spite of stocks having dropped by a huge amount, the P/E ratio was still 26.57. Again, investors fell behind the price drop. Another classic example was at the beginning of the Great Depression of the 1930s. In the late 1920s, the Federal Reserve flooded dollars into the economy to assist the British central bank in managing a floundering post-war British pound. With a massive increase in the money supply, American business artificially boomed.
The so-called “Roaring 20s” were an era in which earnings and dividend payments increased quickly. Every investment seemed to pay off. Stock prices followed but not in excess of the rise in company earnings. Like today, people dreamed about getting rich quick trading stocks. Earnings were so good that by January 1929, the S&P 500 P/E ratio was only a bit under 17.76. That was in spite of skyrocketing stock prices.
By October, 1929, however, the P/E ratio still stood at 17.83. By February 1933, when stock prices had finally fallen to about 10% of their value in 1929, the S&P 500 P/E ratio was 14.88! Here is the bottom line… in spite of the 90% decline in stock prices, the P/E was not very different from when prices were 900% higher!
What does that tell you, my friends? Many may be wondering how this could be possible? Most of your adult life, or at least that part of it in which you’ve been listening to the propaganda from talking heads, University Professors, and business media writers, you’ve always been told that P/E ratios matter.
They do matter, just not to whether a stock is about to go up or down. They matter with respect to the ability of a company to pay you a certain level of dividends. With respect to everything else, forget all P/E ratios. In a perfect world conceived in unrealistic economic theory, the P/E ratio might matter. It just doesn’t matter in our world.
That’s because in a stable economy, earnings would be a measure of how well run a company is. But, we don’t have an economy like that. What we have are central banks who determine bull and bear markets, by flooding money in and out of financial markets. The efficiency of company management is a factor, but a small one, when you compare it to the overall financial conditions created by this central banking manipulative activity. That’s why, in our world, the P/E ratio has no predictive value.
In the real world, earnings react to the money supply just like stock prices. When the money supply goes up, and interest rates go down, earnings go up and so do stock prices. The situation ends up artificial and temporary but that is what happens. You can complain about it all you want. You should complain and try to change things. But, for now, it’s as simple as that.
That’s why P/E ratios cannot predict individual share prices in the future. It is also why they certainly cannot predict whether or not a bull or bear market is on the way. Remember, again, that the earnings of all companies ALWAYS go up when a central bank increases the money supply. That’s got nothing to do with the quality of the management team in any one company, or all the companies listed on the S&P 500 index.
The decisions of the central bank and the government are the primary things that determine whether stock prices crash or continue upward, but there are a few relevant questions you can ask. Once a lot of money has been printed, is the central bank going to significantly raise rates? Will they constrain liquidity? Will they narrow the loan windows from which banks can loan hedge funds and other speculators money? If so, there will be a crash.
How big the crash will be is determined by how big the preceding bubble was. But, if they never raise rates, constrain liquidity or close loan windows, the ultimate result will be a collapse of the currency itself. To keep a boom going you not only can’t significantly raise interest rates, but you’ve got to keep the money spigot open and flowing. The amount of time it takes to collapse is primarily determined by how clever and believable the countering propaganda is.
In practical terms, going forward, if the Federal Reserve allows interest rates to rise significantly, it won’t matter whether the S&P 500’s P/E ratio is high or low. Earnings will fall, and the P/E ratios will rise unless stock prices drop (which they will). The current P/E ratio will have nothing to do with that.
Don’t get me wrong. What I have just told you doesn’t mean stock prices are about to crash. It just means that you should not be relying on P/E ratio’s to determine whether there is “froth on the stock bubble”, as some pundits like to put it. Current P/E ratios have NO VALUE in predicting future P/E ratios and, therefore, no value in predicting price movement.
The fact that P/E ratios are not in the stratosphere, right now, will do nothing to stop or slow down a potential stock price crash. That’s why, in my opinion, the safest bet, right now, is not general stock investment at all, but rather precious metals and mining companies. I don’t come to this conclusion based on P/E ratios, but on the probability that the Federal Reserve will be raising interest rates, and the fact that there is an insufficient quantity of gold to supply the market, as explained in more detail here.
History tells us that it is more likely that stocks will decline if P/E ratios are astronomically high and prices have already been heading down. But, almost all major stock market crashes including the Crash of 1929, the dot.com Crash of 2000, and the “Great Recession Crash of 2007 – 09” BEGIN with very modest S&P 500 P/E ratios. Therefore, be careful to evaluate the future based based on what the central bank does, not on P/E ratios.
Appended, below, is a list of the S&P 500’s P/E ratio at all points discussed in this article.