Is the S&P overvalued right now? Or is it the beginning of another huge bull market? This post revisits historical P/E ratios collected by Robert Shiller, author of Irrational Exuberance (all data can be found on his web site).

The following chart tracks the Price to Earnings ratio of the S&P 500 over the last 100 years. For those who do not know, a P/E ratio is the stock price (in this case the whole market) divided by the sum of all corporate earnings. For these calculations, Shiller uses the average earnings of the previous 10 years.

The stock market reached P/E ratio peaks in 1929, 1966 and 1999. Each of these years was preceded by price growth of over 10% annually for a decade or more. Using Shiller’s data, I have organized the expansion and contraction cycles of the U.S. economy for the last 100 years in the chart below. The dates were chosen to coincide with the P/E ratio peaks and valleys.

As you can see from the charts above, the length of cycles last anywhere from 9-25 years. The rip-roaring 20s saw the stock market increase 19% annually over 9 years while corporate earnings grew only 8% a year. The result was a massive stock market collapse between 1929-1933 where the stock market lost 85% of its value. The Great Depression followed as the only time in recent history where the U.S. had negative average earnings growth for over a decade.

The second growth period occured after WWII and lasted nearly 25 years. The S&P grew at 11% annually while earnings grew only 7% per year. After the 1966 peak, the stock market stayed flat for over a decade while rampant inflation ate away at investors’ purchasing power. In 1978, the stock market was at an almost identical nominal level as in 1966 even though it’s real value had decreased over 50% due to inflation.

From 1980 to 1999, the stock market had its greatest run of all time. Although not as explosive as the 1920s, the latest stock market surge lasted 20 years and was much greater in terms of overall price growth. The P/E ratio of the S&P 500 reached an all time high of 44 in 1999. The stock market has finally reached its 1999 nominal peak again even though it has declined by more than 20% in real terms. The P/E ratio has declined, but still remains as high as every other peak in the last 100 years besides 1999.

How can the biggest growth period in history be followed by anything other than an extended recession?

I see two options for how a stock market correction might play out: either a 1929-like stock market crash or a 1970s-like inflation cycle. We seemed to have dodged a 1999 crash by the Fed lowering interest rates to 1% in 2001. Combine that with a post-September 11th patriotic optimism and you can fight off a recession. I’d bet more on the latter although either scenario is possible. If the stock market keeps pushing up like it has in the last four months, a future crash might be more likely.

Corporate earnings dropped almost 50% from 1999 to 2001, but then rose almost 150% in the last four years. Have we had such a productivity revolution in this country that we can expect this kind of growth to continue? Can we think of any bubbles in the last four years that might have artificially driven up earnings? (think: housing!)

In no other time in history was a P/E level of over 20 sustainable. I’m betting this time is no different.