By JLP | August 31, 2010
From page 321 of John Bogle’s book, Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition*:
“In the shorter run, the irrationality in stock returns is created by the speculative element. Stock market irrationality can be measured by the ephemeral—but critical—factor represented by the stock market’s price-earnings ratio. If, following Lord Keynes [John Maynard Keynes], we use the term investment to describe the fundamental return based on earnings and dividends, we use the term speculation to describe this second determinate of stock prices: the price that investors will pay for each dollar of corporate earnings. If the power of fundamentals dominated market returns in the very long run, the power of speculation dominates market returns in the shorter run. Speculation is, ultimately, temporary and fickle. Over time, investors have been willing to pay an average of about $14 for each $1 of earnings. But if, in their optimism, they are willing to pay $21, stock prices will leap by 50 percent for that reason alone. If, in the pessimism, they are willing to pay only $7, stock prices will fall by 50 percent. The changing price of $1 of earnings creates powerful leverage indeed, but it doesn’t last forever, nor even for an investing lifetime.”
Like the post from earlier today mentioned, the reason P/E ratios are lower than normal right now is that investors are not confident about future earnings. A stock that has a P/E ratio of 10 isn’t a bargain if future earnings are lower than current earnings. But, that is short-term thinking. If, as Bogle stated in the paragraph above, the historical P/E for that particular company is 14, and the current P/E is 10, it could be a good time to buy the stock to hold for the long-term.