Thursday, April 9, 2009

New Measure Suggests Stock Market May Have Hit Bottom

Jeremy Siegel An Economist at the U Penn has come up with a new way to look at the price to earning ratio (P/E) (see an article here). P/E tells us for a given stock price how much the stock earns [or price divided by earnings]. Typically this ratio is about 15. To find the P/E ratio for the whole market, Standard and Poor's adds up all the prices of every stock in their S&P 500 index, then adds up all the earnings. The total market P/E just take those to sums and divides them.

Siegel points out this means that AIG's losses are just as important as Exxon's gains. However, investors own 20 times as much Exxon Stock as AIG (since AIG is worth a lot less now). Siegel argues that Exxon should be weighted more heavily. In other words we should count Exxons gains 20 times as much.

Siegel claims a weighted P/E ratio is most important when a few companies have giant losses. This means current P/E may be too pesimistic about the outlook of the stock market. Siegel thinks we have already hit the bottom of the market.

I guess the real question is the weighted P/E more predictive of where the stock market is going than the P/E?

h/t to Greg Mankiw

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1 comment:

Linus said...

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