You'd think this would be a very short article, on the order of, "The long-term average P/E (price to earnings ratio) of the Dow Jones is around 16." End of story. But before that information becomes useful, there are several other factors you need to take into account.
How Long Is Long Term?
In 1896, the Dow Jones Company first published a list of 11 industrial stocks, totaled their prices, divided by 11 and called the result the Dow Jones Industrial Average, the DJIA. But this was a very different world. No one has published a study of the Dow Jones P/E long-term average that includes data from the present all the way back to the 19th century for the good reason that while it might be interesting, reliable 19th century P/E data isn't available and even if it were, it wouldn't be especially useful. Too much has changed.
Another possible starting point is 1929, the year of the stock market crash that led to the Great Depression. From there, P/E data exists, but even so, when most contemporary economists assemble long-term data for price and P/E, they start somewhere in the 1970s because the more recent the data the more likely it's relevant to the current market.
Why Does P/E Interest Investors?
The usual reason investors are interested in looking at long-term P/E ratios is for what they say about the near-future direction of the current stock market. The assumption is that when the P/E ratio is considerably higher or lower than the historical average, this predicts how well the market is likely to do in the near future. When P/E's are low it's generally considered a good time to buy stocks; in fact, it's one of Omaha billionaire Warren Buffet's most important criteria. When P/E's are higher than the long-term average, investors tend to think the market is overvalued and may wait for a correction before buying.
How Predictive Is It?
These assumptions aren't exactly wrong, but they need to be qualified.
The first thing to note is that unless you're buying a Dow Jones Index fund or exchange-traded fund (ETF) that holds these same 30 Dow Jones stocks, what's going on with these huge corporations, some of the world's largest, isn't necessarily the most useful representation of what's going on in the overall market. An index like the S&P 500, although it's still slanted toward elite companies with valuations of over $6 billion, because it includes 500 companies instead of 30, might come a little closer to what's going on in the market generally, where there are many more small caps – stocks with values under $2 billion – than these rarified giants. Also, what's more immediately relevant when you're buying a stock, is the P/E of that particular stock, not the P/E of the entire market. Individual P/E's range widely from under five to over 500.
But the other thing that's important to realize is that in the short term, there's little correlation between index ratios and market direction. A Goldman Sachs study shows that so far as predictive value goes, even the broader S&P 500 Index, "Is a disaster when it comes to signaling what the stock market will do in the near term." This, of course, contradicts popular wisdom, but it's widely understood among economists and market professionals. Both Warren Buffet and Nobel Prize-winning economist Robert Shiller have specifically warned investors not to rely on P/E's alone to make short-term investment decisions. A case in point is Amazon, which in June 2014 had a P/E of over 800. Obviously, a terrible buy. Except that over the next four years Amazon's stock value increased about 500 percent.
Then What Good Is It?
The good news is that P/E's aren't entirely useless; they do have predictive value, just not in the near term. The same Goldman Sachs study concluded that if the timelines were greatly extended then, yes, there's a correlation; starting P/E levels are strongly correlated with 10-year annualized stock returns.
And in Conclusion
The Dow is probably not the best index to use as a source for historical P/E's. Any number of broader indexes give a more accurate idea of what's going on in the market generally. While P/E's aren't useful in determining what's going to happen in the market tomorrow, next month or even next year, they do give you meaningful information in the long term. That's why P/E's are useful to someone like Warren Buffet, whose remarkably successful stock market strategy consists of buying undervalued stocks and holding them for a very long time. It's a strategy worth considering.
- AdvisorPerspectives: Is the Stock Market Cheap?
- Evanson Asset Management: Stocks for the Long Run?
- FA Mag: The Fortune 500 vs. The S&P 500
- Gold Eagle: Stock Market Historical Valuations 1925 to 2007
- Investopedia: How Now, Dow? What Moves The DJIA?
- Observations: Dow Price/Earnings (P/E) Ratio History Since 1929
- Yahoo: Before You Predict the Next 12 Months in the Stock Market, Consider One Chart
- Seeking Alpha: Predicting Stock Market Returns Using Shiller-CAPE And PB
- Amazon PE Ratio History
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