Another thing to consider when looking at PE ratios in a historical context is the level of tax rates. Consider the following (when I say pre-tax, I mean pre dividend & capital gains taxes):
In 1974 - the top marginal tax rate was 60%, dividends were taxed at the marginal rate, and capital gains were taxed at 36.5%. Based on the PE chart in a prior post, the PE ratio was roughly 9X in 1974 for a pre-dividend/capital gains tax yield of 11.11%. Assuming the market payout ratio was 50%, the after-tax yield drops to 5.75%, and the after-tax PE is 17.39X.
Currently - the top marginal tax rate is 35%, and dividends/capital gains are taxed at 15%. Again, assuming a 50% payout ratio, the after-tax yield is 3.88% and the after-tax PE is 25.74X.
So - the current market pre-tax PE of 21.88X divided by the 1974 pre-tax PE of 9X is 243%; however, the current after-tax PE of 25.74X divided by the 1974 after-tax PE of 17.39X is 148% - a huge discrepancy due to the difference in tax rates.
The 1974-equivalent PE ratio based on today's tax rates can be calculated as follows: 1974 pre-tax earnings yield was 11.11% (100/PE of 9) and the after-tax earnings yield was 5.75% - let's call 5.75/11.11 the after-tax yield margin, which was 52% in 1974; currently the pre-tax earnings yield is 4.57% (100/PE of 21.88) and the after-tax earnings yield is 3.88% for an after-tax yield margin of 85%.
If we divide the 1974 after-tax earnings yield of 5.75% by today's after-tax yield margin of 85%, we arrive at a 1974-equivalent pre-tax earnings yield of 6.76%. By dividing 100 by 6.76, we arrive at a 1974-equivalent PE ratio of 14.78X.
It would take a 32% drop in the market to reach this "1974-equivalent" PE ratio and 54% drop to reach the "Golden Level" of 10X.
In order to evaluate the fair value of the market, one must look at interest rate levels. The BAA yield averaged 9.58% in 1974 for an after-tax yield of 3.83% (based on a 60% marginal tax rate), and the current BAA yield sits at 6% pre-tax or 3.90% after-tax (based on a 35% marginal tax rate).
For the sake of argument, let's assume the after-tax BAA yield is an appropriate rate to use to capitalize after-tax market earnings. In 1974 the after-tax earnings yield was 5.75% versus the after-tax BAA yield of 3.83% - assuming the market should yield the after-tax BAA yield, then one could say the 1974 market was undervalued. Today's market yields 3.88% after-tax versus an after-tax BAA yield of 3.90% - hence, one could say today's market is roughly fairly valued.
I say all this merely to point out that tax rates make a HUGE difference when comparing PE ratios across time periods and that investors waiting for 10X PE ratios may be waiting for a long while. I hope I am wrong though because a 10X PE market would be a dream.
(Excel sheet with calculations attached)