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High P/E ratios don’t bode well for future returns

The spread between the current price-to-earnings ratio of the S&P 500 index stocks and its trailing three-year simple moving average came back to earth in the second quarter as equities fell. Historically, high P/E ratios have led to market underperformance, with three-year annualized index returns near 13% once the P/E ratio crosses the 17-times-earnings threshold.

At Friday's close, the P/E ratio of the index was 20.7 times earnings, for a difference of 0.5 over its simple moving average; that spread peaked at the end of February at a difference of 2.8. Since the start of 2010, the correlation between the spread and the following three-year return has been stoutly negative.