How The S&P 500’s P/E Ratios Can Levitate

Economics writer Robert Samuelson is worried. Specifically, he’s worried about why stock prices have risen so much in response to Donald Trump’s election as U.S. President on 8 November 2016.

In worrying, he not only conveys the conventional wisdom that seeks to explain the “Trump Rally” as some sort of outpouring of animal spirits linked to the promised policy changes that Donald Trump advocated on the 2016 campaign trail, but also zeroes in on the historically elevated price-to-earnings (P/E) ratio of today’s stock market.

The theory of the Trump Rally is simple: He has brightened the economic outlook. Big business and personal tax cuts, combined with relief from over-regulation and higher infrastructure spending (roads, ports), will boost economic growth. Faster growth will raise profits — and higher profits tomorrow justify higher stock prices today. In theory, stocks represent the present value of (estimated) future profits.

But there’s the rub. What if those profits don’t materialize?

Immediately after the election, it was possible (though naive) to think that Trump could quickly convince the Republican Congress to pass his economic agenda. Now, that optimism seems unrealistic. The difficulty of repealing the Affordable Care Act showed the limits of the White House’s power. Similarly, big tax cuts may be doomed by budget deficits. Progress on infrastructure and regulation is also grudging.

So: If the main reason for the Trump Rally is missing, what’s holding stock prices up? Good question.

Let’s be clear: Stock prices are historically high by many traditional measures. Consider the price-earnings ratio, or P/E. It shows the relation between stock prices and underlying earnings (profits). Since 1936, the P/E ratio of the Standard & Poor’s 500 stocks has averaged 17 based on the latest profits and stock prices, says Howard Silverblatt of S&P Dow Jones Indices. Now, the P/E is almost 24.