Price to Earnings

Probably the most widely used valuation metric, for its simplicity, is the Price to Earnings ratio. The chart below shows three P/E of the S&P500 and the P/E of the 10 year U.S. treasury (which is simply the inverse of its current yield). In the chart you can see that since the 70’s, until the dot.com in the ‘99-‘00 period, both ratios where hand in hand. The bubble in that period, fueled by #y2k and by Greenspan’s monetary policy, crated the first great distortion, where P/Es diverged 50% and 60% from neutral. But it’s in the aftermath of the #gfc where you can see the great divergence: P/E for bonds started to diverge from the equity one when the Fed started its #qe and #zirp experiments, with bonds reaching a 319 P/E. Remember that the 10year bond is used as a discount factor to obtain fair values for equities. But when it’s in bubble territory, it’s worthless as an input. Thanks to the inflation created by these experiments and the subsequent #ratehikes, both P/E have converged again, and we are back to neutrality. But the same way we saw the reaction to the other side during the 2000’s, we may see it now, and that would imply higher yields, which subsequently implies lower P/E for equities, or multiple compression.