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

Chart 28

Price/Earnings Ratios Can Be Deceiving

In 1929 prices were sky-high, and any rational simpleton should have seen the bubble that was too big and about to burst. Right? Wrong. You see, earnings, which are what most investors use to value stocks, can be misleading. Lower price/earnings ratios (P/Es) don't always mean stocks are getting cheaper. Even most pros have a tough time believing it, but these were the conditions leading to the Crash of 1929. Despite a doubling since 1926, and a quadrupling from 1913, most folks were suckered into hanging on and buying more overpriced stocks because P/Es seemed OK and were falling lower.

The Dow Jones Industrials' P/E was 20 in early 1927, and the market moved up 30 percent. But earnings increased even more. So why should folks be afraid when by year-end the market's P/E was just 13? Irving Fisher (no relation to me) was by far the most noted economist of his day. From his pulpit at Yale, he pontificated that stocks were not too high because earnings were rising still faster. This, Fisher maintained, was evidence of the economy's vigor. His view is shown on the following page. This chart appeared in his 1930 book The Stock Market Crash and After—a telling example of how wrong an “expert” can be. In 1930, with the market partway down its three-year suicide run, Fisher argued at length that there was nothing further to fear, because P/Es were reasonable and falling.

The solid dark line on the chart represents the average P/E for each ...