Is Forward P/E Ratio a Good Predictor for Market Returns?

January 16, 2013

Today’s Chart of the Week looks at the historic level of the S&P 500 Index relative to the forward estimated price-to-earnings (“P/E”) ratio of the S&P 500 from January 1, 2006 to January 15, 2013. The purpose of this chart is to see whether or not the forward looking P/E ratio can predict performance of the index. The P/E ratio compares the value of the share price to estimated earnings per share over the subsequent year. A higher P/E suggests that the market may be approaching a downturn, while a lower P/E may represent a buying opportunity and potential for market gains. Over the last seven years, the forward P/E ratio has averaged 12.5 (depicted in green).

The correlation between forward P/E ratio and the following one year return has been negative, which is to be expected: as suggested above, lower P/E ratios are typically followed by a rising market, while higher P/E ratios have predicted negative returns. Looking at the chart, we see that this basic intuition is supported: low P/E ratios are followed by rising markets. However, the correlation has not been especially strong, with a value of -.39 for the seven years studied in this analysis. More importantly, the correlation has not been stable over this time period, thus making the reliance on forward P/E ratios to predict market performance relatively useless. Certainly, outliers of this ratio – such as its extreme low value on March 9, 2009 (the date that the market bottomed following the financial crisis) – have been useful indicators of extreme market conditions, but they have not proven to be a consistent market predictor.

Therefore, inference of 2013 stock market performance based upon the most recent figure of 11.9 (below the long term average of 12.5) is not meaningful. As much as we would like to extract a precise prediction for the following year’s stock market performance, the relationship between the two variables is not strong enough to predict future performance.