Rule Breaker Mailbag: Are Historic Market P/E Ratios Still a Good Gauge of Market Frothiness?

In this segment from Rule Breaker Investing, Motley Fool co-founder David Gardner gives some thought to what his questioner views as a natural outgrowth of the idea that "winners keep winning." We can gauge whether a market is "pricey" or over-exuberant based on how price-to-earnings (P/E) ratios generally look compared to historic averages. However, this needs to be seen in the context of interest rates.

When interest rates are low, investors, both international and domestic, may see more opportunities in the U.S. stock market than elsewhere. With more money flowing into U.S. markets, the historical P/E ratio may be less significant. David gets to the heart of matter.

A full transcript follows the video.

This video was recorded on May 31, 2017.

David Gardner: This is a letter in from Ashish Gajjar, a member of Motley Fool Million Dollar Portfolio service. Thank you Ashish. "Hello, David. Thank you for taking my question. One of the tenets of Rule Breaker Investing that you've espoused can be roughly analogized to the notion that 'winners keep on winning.' As investors, we hope this plays out in a company's rising stock price as a reflection of that company's market cap, its valuation. So [if] the company can keep winning, when it comes to greater earnings it may also likely keep winning as it comes to optimism or demand for the limited number of its company shares, thereby increasing the share price. If the latter accelerates faster than the former, the P/E ratio, the price-earnings ratio will increase."

Ashish goes on. "I frequently hear that the market is rich, or frothy, or pricey, and the basis of this is comparing historical P/E ratio trends." So just to interject here, people will say, "Look at the market's P/E. It's 17 or 19 right now, and that's above the historic mean of, let's say, 14 or 15." You'll hear that kind of talk not just today or this month, but all the time. Every year. Back to Ashish's note.

"But is one caveat not that there's much more demand for U.S. equities, in general, now than ever before? With freer markets, the expression of global demand for finite or limited goods -- whether they be stocks, or collectibles, or real estate -- would tend to drive up prices faster than earnings might increase. I understand this creates a so-called bubble, you say, which may eventually burst or correct, all terms we tend to avoid in Rule Breaker Investing." And you're right. Thank you.

"But, can we not take some solace in the fact that the bubble itself, expanding, is a natural consequence of greater global wealth seeking to invest in quality securities? Many of these are likely to be Rule Breakers." I'll end it there, but you said big fan of the show and The Motley Fool. Thank you, Ashish.

So the question is basically about the historic market P/E and whether it's a good gauge, and why it is where it is today if it's looking higher, which it is, than usual.

And I want to say two things quickly about this. The first is that the price-earnings ratio has to be considered in the context of the interest rate atmosphere -- the environment in which any market exists. Very simply, you have a choice with your money. You could just put it in the bank or buy a bond. Something that pays you interest. You could lend that dollar out.

Or you could take more risk and invest it directly, possibly losing the whole dollar or some portion of it, not necessarily winning. So you always have that choice -- to go safe by lending it, or to go riskier by investing it. And when interest rates are really low, which they've been for a long period of time, naturally there's not a lot of incentive to invest in things that pay interest. Therefore, people buy stocks and therefore P/E ratios augment, they accelerate.

So it's not just about a number that sits in a vacuum like 19 versus 14. I think you have to understand P/E ratios within the context of the interest rate environment in which we live. So if and when interest rates climb, that hurts stocks. It always does. And if they were to climb dramatically, that would sink the market for a period of time. There's no question about that.

All that said, my second point about this is that I spend very little time concerning myself with historic market P/E ratios. I realize very serious-minded people, some very impressive people -- academics, economists, market forecasters -- care deeply about these numbers, but my observation about them, and maybe the Rule Breakers aside to you, is that it's usually a very short-term context that they're thinking about the market. They're thinking about the market in 2017, or they're worried the market might be high this summer. That kind of thing.

For those of us who've made a lifelong commitment to being an investor -- that is, to having our capital in the market -- and not guessing, not head faking ourselves out of bull markets or buying at the top of the market sometimes, which is a mistake that I make every time I invest my next two-week salary -- if the market's high, I'll look back and say, "Wow! I bought at the top of the market." You might have, too. But the point is I really don't get too concerned about market valuation, and with every passing day -- and I'm now 51-years-old -- I try to spend less time thinking or guessing about where the market is, where it should be, or where it's headed. The truth is, when you and I invest, we're not buying the market unless we buy an index fund. We're buying individual companies.

That's what I do in Rule Breakers and that's what we talk about, here, in Rule Breaker Investing. And so we're really just owning companies. We're becoming part owners of great enterprises that have wonderful products and services. Sometimes life-changing, life-benefiting, world-benefiting products and services driven by great management and lots of good capital all around, and they tend to grow over time. That's the simple game that we're playing.

So Ashish, I don't know if that was helpful for you, because I didn't really answer, ultimately, what the market's P/E should be. I do think, again, it should be in the context of interest rates, and I do not care that much about it at any given day, month, quarter, or year.

I guess I should add an addendum. If you're at or near retirement, it probably matters more to you. It's a little easier for me to say at the age of 51 that I don't pay as much attention. But if I were trying to pull all my money out of the market in the next five years to retire, I would be more focused on it, and I realize that I'm certainly speaking to people, as I say this, and that [may] describe your case.

And for you, sir and ma'am, I hope that you will be smart about investing. Usually what we do is we're incremental. So as you start approaching the time you're going to need that capital as opposed to just growing it, I would suggest that you start to transition it over.

You'll get good answers on the Motley Fool Answers podcast or our Rule Your Retirement service in terms of how to think about the overall context of your portfolio approaching retirement. But I'm giving the more timeless answer that I have, at least at this stage of my life, which a lot of us have if you're thinking more than one decade ahead with your money.