Courtesy of Chart of the Day...
The top chart shows the aggregate earnings, over time, of the companies
in the S&P 500 Index. The second chart shows the ratio
between the aggreagte price of the stock, and the earnings of the
Oversimplified view: A low price-to-earnings ratio means that you are
not paying much, to get a share of a company that is earning a
lot. A high P:E ratio means that you are paying a lot for
companies that aren’t earning so much. Although there are many
factors involved in determining whether a certain stock is a good
investment, a lower P:E ratio is one indicator that suggests that the
stock is a good investment.
What remains to be seen is whether the turn things around, to get their
P:E ratios down. But until you see that happen, you really don’t
know what you are getting into, if you buy stock in these
Historically, the P:E ratios have been cyclical. So some people
will be tempted to assume that the P:E ratios will cycle down, turning
their iffy investments into good ones. However, the current
situation is unprecedented. That indicates that the old patterns
and assumptions may not apply at this point in time.
This is an illustration of how assumptions can lead to false
conclusions. It is impossible to conduct one’s life without
making assumptions. Given that, it is helpful to be mindful of
the assumtions one makes when making important decisions. It then
is important to look for indications that those assumptions might not
When you see things happening that are literally unprecedented, it is
an indication that it might not be valid to assume that historical
patterns will repeat themselves.