PE ratio

When you consider valuations, there is an underlying logic that is not exact but exercises a control. For example, if a stock earns $1 a share and has no other major known changes, it is likely to have a stock valuation approximating the effective P/E ratio for that industry. Now P/E rations have a number of components, first, what is the underlying T-Bill rate plus expected inflation plus a risk factor by industry and company. So, if the interest rate is 4%, inflation is 1% and risk is 1% you have a .06 or a P/E of 1/.06 or 16.6. Now, the odds that the stock will trade at that exact ratio is unlikely since other factors come into consideration, such as current market sentiment, rumors, market balancing etc. but the odds are very good that it will trade within a few points of where the P/E says it should.
Now, let’s assume the S&P earnings are projected to be $75. If you multiply that by a P/E of 15 you get 1125 which is not far off from where it is now. Of course 15 is a very nominal value and with interest rates as low as they are now, you could easily argue that a P/E as high as 18 would be appropriate. At 18 (5.5% return) the S&P could rise to 1350 and be in an area that fits its valuation.
Of course if you expect interest rates to rise the earnings return has to increase also and the valuation should be adjusted. However, the current valuation has basically nothing to do with where the S&P was a year ago. Even if you believe that the S&P was appropriately valued last March, the current increase since then is not a valuation factor. It may be interesting, but if your current valuations are supported, that is all it is, interesting. When I hear analysts saying that you can’t expect the rate of increase that we have seen since March continue, that statement has two attributes, first, it is probably correct since the rate of increase is probably going to change (it usually does) but it is also fallacious if it implies that the stock market cares what the rate of increase was.
Simply put, while there is still a lot of nervousness, American industry has figured out how to make profits while reducing staff and inventory. Some of our classic indicators, such as employment or inventory levels are not working right now, but the oldest indicator, company profitability is just as reliable as it ever was.