April 17, 1998

On a total return basis, the S&P 500 index has increased 257% since the end of 1994. Over the same period, the S&P500 price-to-earnings ratio increased to 27.6 from 15 (Figure 1). We attribute these gains in large part to Alan Greenspan's commitment to a domestic price rule monetary policy and to the absence of tax increases. In fact, one could argue that the tax environment has actually improved somewhat. But regardless of the cause, one fact is irrefutable: The run up in prices has resulted in what some investors consider a high price-to-earnings ratio, which raises two interesting questions. First, how high can the P/E ratio go? And second, does the P/E ratio have mean-reverting tendencies -- and if it does, how can a portfolio manager take advantage of the reversion.

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