In the 1960s some researchers wondered, just like you, if the PE ratio was a measure of subsequent market performance.
In a comprehensive study done in 1968 the relative performance of high versus low PE stocks was analyzed. 189 companies in 18 industries over the 25 years between 1937 and 1962 were assessed.
The stocks were divided into 5 equal groups solely according to their PE rankings. The quintiles were rearranged by their PE ranking for periods of one to seven years. Recasting the quintiles annually on the basis of new PE information resulted in the stocks most out of favour showing a 16% annual rate of appreciation over the total time span. On the other hand, switching in the highest PEs on the same basis resulted in only 3% annual appreciation over the period.
Even though the performance discrepancies were reduced with longer investment periods, even after the original portfolios were held for seven years the lowest 20% did almost twice as well as the highest.
Source- Financial Analysts Journal ( 1968)
Paul Miller Jr. presented similar results.
He divided companies not quintiles according to their PE.
Highest PE stocks generated 7.7% CAGR between 1948 and 1964 while the lowest PE stocks generated 18.4% CAGR.
It was also found that the lowest 20% of stocks, ranking according to PEs did best in 12 of the later 17 years. The highest 20% did best in only 1 subsequent year and worst in 8.
Source- Drexel & Co
Another study divided the 6000 stocks on the Compustat tapes into five equal groups as per market size, for 21 years ending in 1989.
Each group was then divided again into five subgroups according to PE rankings.
The low PE stocks outperformed the high PE groups for all market sizes from nano cap to mega cap.
Another study was performed in which a sample was prepared from Compustat 1800 which featured the largest public American companies. Yet again, it was divided in quintiles. Portfolio was recast as per new PE information. The period under consideration was August 1968- August 1977.
Results: Lowest PE stocks outperformed the index by 50%.
This was a tumultuous period for stocks.
It was the post was period of 1973-1974.
In 1994, in an article published in the Journal of Finance, Lakonishok, Vishny and Shleifer presented the outperformance of low PE stocks.
They used the thousands of companies on Compustat tapes from 1968 to 1990 selecting stocks listed on NYSE and AMEX to eliminate stock selection bias.
An annual recast based on PEs was performed.
Low PE stocks generated the highest return of 17.8% beating middle and high PE stocks as well as the index which generated 15.1%
Also, low Price to Book, low Price to Dividend consistently outperformed the market.
In a study considering the period between 1970 and 1996 stocks on the Compustat 1500 were divided into quintiles based on PE.
The lowest PE stocks outperformed the market by 144%.
What happens in a bear market?
Between 1970 and 1996 markets fell by 7.5%
Low PE stocks fell by 5.7%.
And, low PD stocks fell by 3.8%.
And, let me make it amply clear that I’ve nowhere in my post claimed that the efficient market hypothesis is valid.
But, quoting leading investors and influencing our decisions based on their quotes is an ill considered move.
Hardly anyone knows where the market is headed.
It’s seldom predictable and the tidy success stories of rags to riches in markets are made palatable to the masses by ignoring in totality the role of luck.