August 12, 2025

The Price-to-Earnings, P/E, ratio is a key financial metric widely used by investors and analysts to evaluate and determine whether a stock or index ETF is overvalued or undervalued from which valuation driven investment strategies are developed. If an asset is deemed overvalued , a reduction in the exposure to such an overvalued asset is the appropriate investment decision. The P/E valuation and investment strategy outlined assumes that deviations from the benchmark P/E ratio revert to the benchmark. That overtime deviations are dissipated and the actual P/E returns to the benchmark P/E ratio. The strategy also assumes that price changes dominate the changes in the earnings as the P/E fluctuates and or reverts its mean value. Under these conditions a P/E ratio in excess of the trending benchmark P/E is prima facie evidence of overvaluation. In this environment, the fluctuation in the P/E ratio leads to an active strategy that takes advantage of the mean reversion: Buy the below average P/E stock that is experiencing an increase in its P/E ratio and sell the above average P/E stock whose P/E ratio is rising. Our analysis shows a link between economic policy and the changes in the P/E ratio. This is an important insight suggesting that incorporating a macroeconomic analysis into the P/E investment process may allow the investor to anticipate the changes in the P/E ratio and thus develop a quicker response to the changing economic environment.

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