Styles RouteMap: Cyclically-Adjusted P/E Ratio

Buy when the yellow line is low, sell when it is high


sample chart showing cyclically-adjusted PE in yellow.

This strategy shows how cheap or dear is each sector or style. It shows the PE ratio after EPS has been cyclically-adjusted by smoothing out over a typical economic cycle.
 
The index is shown in as the thick white line on the right hand axis. The explanatory variable, the PER ratio, the yellow line, use the left hand axis. For comparability, stock market indices have been rebased to set year-end 1994 at 100.
 
Please note that comparisons between countries are subject to differences in the reporting of corporate profits. In general Earnings Per Share may be over-stated where there is a tradition of profit maximisation and early adoption of full consolidation of subsidiaries, as in Anglo-Saxon countries, and under-stated where the interests of outside shareholders may take second place to tax minimisation. In recent years these differences have begun to diminish.

It differs from the well-know Graham and Dod PE Ratio in two respects. Firstly it normalised EPS not over ten years, but over a typical four year economic cycle. Secondly that reduces the need to deflate both EPS and Index by inflation to remove money illusion.

Please note that a similar type of chart for countries and regions includes an additional third modification for inflation, but that sophistication is unnecessary here, where comparisons are normally within the same country or region. See Stock Markets > Cyclically-Adjusted Real PE 

These modifications generate much more useful valuation ratios in that they swing through a narrowed range and do so more frequently, than the once in one or two decade extremes of the Graham & Dod PE ratio.