The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 1

Price/Earnings Ratios: Then and Now

I bet you'd bet that price/earnings ratios (P/Es) were sky-high in 1929. You lose. They were no higher than in the 1986–1987 stock market. That's scary. Why? When a stock price is high in relation to a company's earnings, the stock is usually overpriced. When all stocks are high-priced in relation to earnings, the market is usually ripe for a rip-roaring retreat. You know what happened after 1929. Almost every other time P/Es were this high, the market has done poorly too. With the Dow Jones Industrials averaging 19 times earnings in 1986, this graph was crying out a shrill warning from my dusty library shelves.

The graph came from a 1975 research report issued by the brokerage firm of Goldman Sachs. There is nothing unique about it except its simplicity. The Value Line graph (Chart 11) gives greater detail on P/Es, but is harder to draw conclusions from due to its added clutter. What you do see right off is that only a few times has the market sold at P/Es greater than 20, which is marked with a heavy horizontal line. Instead, most of the time, the market sold for less than 15 times earnings.

A great irony is that at the market's best buying points, before the rise in the 1920s and again before the rise coming out of the Great Depression, P/Es were sky-high—essentially infinite—because there weren't any earnings, as you can see on the accompanying chart. But it's rare, and it isn't the world we're facing as this book is coming to print. ...