Mathematics is a language; a number talks to you and as is the case with any language, you can understand what you will.
There have been a number of analysts commenting on high PE ratio's; many have commented on how the median PE since 1929 has run at 15 to 15.5; they go on to observe how the median PE ratios have climbed to 22 over the last 10, 15 and 20 years. They have then concluded that the market is over-valued because the PE ratio has risen over its historic norms.
You can have a high PE ratio and still have a market cheaper compared with a period when the PE ratio's were lower even where the expectations of long term growth and investor returns are identical. An investor gains from dividends and capital gains, the PE is useful in forming an expectation of the future capital gain potential.
Suppose you expect long term earnings growth to run at 7%. Suppose further you have a long term return expectation of 11%. You will derive your return from dividends and capital gains. The long term dividend payout ratio is 50%.
Your multiple is 1 *(1+G)/(R-G)*(1-P); where G (7%) is the long term nominal earnings growth expectation, R (11%) is the investor total return expectation and P (50%) is the payout ratio. The multiple of earnings you should be happy to pay is 13.375 (1*(1+7%)/(11%-4%)*(1-50%).
Now suppose you have identical growth and return expectations, but your long term dividend payout ratio falls to 40%. The multiple of earnings you should be happy to pay is 16 (1*(1+7%)/(11%-4%)*(1-40%).
Now suppose you have identical growth and return expectations, and the company ceases to pay a dividend. The multiple of earnings you should be happy to pay is 26.75 (1*(1+7%)/(11%-4%)*(1-0%).
In the above example, despite the difference in the PE multiple (13.375, 16 and 26.75), all markets are equally valued on a total return basis; there is no relative over-valuation simply because a PE ratio is higher.
To compare like with like you need to adjust multiples. If you take the 13.375 multiple and divide it by (1-P {50%}) you get 26.75, if you take the 16 multiple and divide it by (1-P {40%}, you get 26.75. And of course the 0% payout ratio value is 26.75.
The median PE 6 multiple since 1929 to 2009 has been at 36.95 assuming a 0% dividend payout. The 2009 multiple assuming 0% dividend payout is 28.70. In a historic context, the market is considerably under-valued; the market would need to rise to 1,300 to be valued in line with historic valuations.
The real question to ask is whether the multiple reflects realistic long term growth assumptions and investor return expectations. The Corporate Baa bond yielded 6.6% over the past economic cycle; during this period the 10 year treasury yielded 4.27%. Investors in equity can expect total returns of 9.6% long term; this 3% premium over the Corporate Baa bond which is broadly in line with historic performance of total shareholder returns. The long term dividend payout ratio at present is 40.5%. With the markets at 1,016; the long term growth expectation implicit in the present multiple is 5.91%. As confidence rises, a growth expectation of 6.7% would support a market level of 1,300. Even a subpar real GDP growth rate of 2.5% would make the 5.9% number achievable with an inflation expectation at 3.4%.
With several SP500 companies having significant overseas earnings, a real global GDP growth rate expectation of 5% plus 3.4% inflation would make nominal earnings growth of 8.4% possible; but if this occurs, expect higher interest rates and investor return expectations closer to 11%. This would support a market level of 1,475 assuming a payout ratio of 40.5%.
On balance, for this economic cycle, I believe a 7% nominal earnings growth rate expectation together with a 9.6% long term investor return expectation and a 40.5% payout ratio will take the market to near 1,450. After that it all depends on the long term outlook at that time.
