Apparently, each one of the methods gives different results. Using the Total P/E Ratio method, we get a higher aggregate P/E ratio (compared with the original aggregate P/E ratio in Table 2) in all the four scenarios. On the other hand, the using the Average P/E Ratio method, we get mixed results, depending on the identity of the company that was excluded from the calculation. The P/E ratio is higher when a lower P/E company is excluded from the calculation, and higher in the opposite case.

Interpretation of these results is not straightforward. At first glance, the Total P/E Ratio results seem more reasonable, since the total net earnings is smaller, the index got more expensive. However, an index is not a large company with many profit centers, but rather, a list of many companies that are grouped together by a certain criteria. Given the fact that in each scenario, in three of the four companies there was no change, it seems a bit misleading to claim that the index got more expensive.

In any event, the example in Table 3 is too schematic, since it is more likely that changes in net earnings will be accompanied by changes in market values. For illustrative purposes, let's assume first that the market value of all the companies in the index went down by 20%, with no other changes. The results are presented in Table 4.

This is a very straightforward case: Since the only change is the decrease in the companies' market values, the two aggregate P/Es are also reduced by 20%, indicating that the index became cheaper. A more realistic case is a combination of the examples in Tables 3 and 4. In this case, one of the companies in the index reports a net loss, but at the same time, the market value of all the companies in the index goes down by 20% (similar to the situation that we see in the market nowadays). The aggregate P/E ratios in this case are presented in Table 5, using the same format as in Table 3.

Interestingly, the two methods point to opposite directions. Using the Total P/E Ratio, we get higher aggregate P/E ratios in all the scenarios, indicating that the index got more expensive. On the other hand, according to the Average P/E Ratio method, all the aggregate P/E ratios became lower, indicating that the index became cheaper. In this case, the Average P/E Ratio method seems to reflect the reality more accurately. Since three of the four companies in the index became cheaper, the fact that one company reported a net loss does not seem to justify a higher P/E ratio to the entire index.

Now let's go back to our initial question: Has the U.S. stock market become cheaper?

The Average P/E Ratio of the SPY (as reported by IndexUniverse.com) was 17 as of October 31, 2007. According to Standard & Poor's data, the Total P/E Ratio as of September 30, 2007 was 18. In spite of the month difference, it is evident that the aggregate P/E ratio based on the two methods was very close at the fourth quarter of 2007. The current ratios, as presented in Table 1, are pointing to opposite directions. Based on the analysis presented above, it seems to me that the Average P/E Ratio is a better indicator of the market's direction, and the S&P 500 is now cheaper than last year.

Elli Malki is an economic consultant and the editor of www.inbest.co.il/, an Israeli Web site that provides a decision support service for savers and investors. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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