Three's a Charm

P/E ratios are fickle things. Whenever they seem down and out, they just pop right back up again. Lately, earnings (the "E" part of the equation) have been going up more than prices (the "P" part of the equation). Which means P/E ratios have been falling. In fact, P/E prices have contracted in each of the last three years. Only seven times since 1926 has the market P/E contracted three or more years in a row. In the years following, S&P 500 returns have been huge: an average return of 27%.

So let's say P/Es will contract again this year, making it an even four years in a row. (Currently the S&P 500 P/E is slightly below the year-end 2005 P/E.) This has happened twice since 1926. The S&P 500 returns the year following these periods were 31% (1938) and 32% (1980).

Eventually prices will catch up with earnings. Whether it's three years of P/E contraction or four, 2007 looks like a charming year for stocks.