All of this highlights the pitfalls of the P/E ratio. For starters, earnings are nearly as volatile as stock prices, which makes them tricky to pin down. The standard deviation of the S&P 500 has been 18.8 percent since 1926, while the standard deviation of earnings has been roughly the same at 16.6 percent.
Also, earnings are most elusive during critical turning points in the market, just when investors tend to lean on P/E ratios as a barometer. For example, June 2009 turned out to be one of the best times to buy the S&P 500. But that was obscured by depressed crisis-era earnings for the year through June 2009, which signaled an elevated P/E ratio of 23.1.
Just two years earlier, in June 2007, earnings were riding a misbegotten wave of prosperity. It turned out to be a terrible time for investors, but that, too, was obscured by rosy earnings for the year through that month, which signaled a soothing P/E ratio of 16.4.
There are no perfect answers to the earnings riddle. But Ben Graham -- the father of security analysis -- spotted the problem almost a century ago and suggested an elegant solution. If earnings aren’t as good as they seem during booms or as bad during busts, he surmised, then the most reliable earnings number is an average of earnings over the entire business cycle.
A common estimate of the average duration of a business cycle is seven to 10 years. The 10-year trailing average EPS for the S&P 500 is $89.30. That implies an earnings growth rate of 7.7 percent annually since the financial crisis -- still well above the long-term average -- and a lofty P/E ratio of 26.3.
There will always be apologists for the excesses of stock markets, and they’re often armed with agreeable looking P/E ratios. The next time some slick salesperson points to the P/E ratio and tells you it’s a great time to buy stocks, ask to see their earnings.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.