S&P 500 P/E Ratio at Historical Low

Chart of the Week for June 9-15, 2006

The Price/Earnings (P/E) ratio is one of the most widely watched measures of valuation for both the stock market as a whole, and individual stocks. Because it measures price relative to earnings, many people use it to determine whether the market (or a given stock) is “expensive” or “cheap.”

The most common P/E measure is one that divides current price by historical 12-month earnings.The information in the above chart displays this P/E measure over the past ten years. For instance, consider if the S&P 500’s closing price is 1000 and cumulative earnings per share for the 500 companies in the index is $40. Then, the P/E ratio is calculated as 1000 / 40 = 25.

The P/E ratio of the S&P 500 is near 17 and is at a ten-year low after the recent market decline. In addition, the current P/E level is below 17.5, the average since 1960. There are some reasons behind the current low level of P/E ratio. One is that strong earnings of energy companies have pushed up the earnings of the overall index, which pushes down the P/E ratio. At the same time prices are generally down, as investors have concerns that corporate earning growth may slow down in the near future.

With the P/E ratio of the S&P 500 reflecting potential favorable valuations for large-cap stocks, some long-term investors who have observed large-cap stocks or mutual funds underperforming smaller-cap alternatives are considering current relatively attractive valuation levels. Of course, no one can predict when larger-cap stocks will begin to trend higher versus smaller-caps, so it is important to remain diversified to benefit from market movements as they evolve.

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