The P/E as a Red Flag

In fact, this kind of red flag has appeared repeatedly over fashionable sectors, perhaps most notable in 1998/1999 over the Internet industry. The surprising thing is that investors have not yet fully absorbed its significance.

Investors have certainly seen the situation enough times. Thirty or so years ago, smart investors were buying only into the so-called Nifty Fifty. This elite club included such companies as IBM and Coca-Cola, which in the eyes of many could do no wrong. However, once the P/E ratios on these companies had moved into the 60 to 90 ranges, the party was over. Even these companies couldn’t deliver the profit growth necessary to support share prices at this kind of multiple. The Nifty Fifty subsequently produced way below average returns for close to the next decade.

Moreover, on every single occasion where the P/E ratio for the entire market (not just one sector) has risen substantially above 25, there has subsequently been a marked correction in the market (a sharp fall in share prices).