The current trailing P/E ratio for the S&P 500 sits at around 26 whilst that for the Johannesburg All Share Index is closer to 15. The S&P 500 number is slightly above the average of the past decade but significantly above that of the past several decades. By comparison, the South African market is cheap – posing a conundrum to South African investors. 

High stock market price-to-earnings (P/E) ratios are often hailed as a sign of investor confidence, but they also signal fragility in the financial system. A P/E ratio measures the price of a share as a ratio of a company’s earnings. For example, a P/E of 30:1 says that a market (or share) is priced at 30 times its earnings. When these multiples climb far above historic averages, it means markets are pricing in strong profit growth and low risk for the future.

History offers sobering lessons. Before the market crash of 1929, the dot-com bubble of 2000, and the global financial crisis of 2008, market P/Es surged to levels well above their long-term norms. Each time, the subsequent correction was brutal, wiping out trillions in household wealth. Elevated valuations leave markets vulnerable to shocks, whether from rising interest rates, inflation, or geopolitical crises, because even modest disappointments in earnings can trigger outsized declines.

High P/Es also distort capital allocation. When investors reward unproven business models or companies with weak fundamentals simply because “everything is going up” money flows away from productive, cash-generating enterprises toward speculation.

For ordinary savers, the risk is something to be wary of. Retirement funds, unit trusts, and exchange-traded funds track broad markets, so when valuations break down, pensioners and workers bear the losses. Unlike professional traders, they cannot easily exit positions. A market trading at stretched multiples is therefore not just a technical worry but a household issue that directly affects future security.

The arithmetic of P/Es adds to the danger. If a market is priced at 30 times earnings, even stable profits imply a meagre earnings yield of just over 3%. That yield offers little cushion if interest rates rise or inflation erodes purchasing power. Investors holding equities at such valuations are effectively betting that conditions remain near perfect for years—an assumption seldom borne out.

The flip side of the risk in high P/E numbers is to ask why some markets have very low numbers. In South Africa’s case low economic growth, low investment levels, and high levels of political and policy risk have all been priced into the discounted 15 P/E ratio. However, should those risk factors be resolved by policy makers vast upside potential arises for shrewd investors.

Bheki Mahlobo told The Common Sense: “The lesson is not that high P/Es guarantee a crash, but that they heighten vulnerability. Markets priced for perfection cannot withstand disappointment. Prudent policy, transparent accounting, and disciplined investment are required to prevent optimism from tipping into disaster…low P/Es reflect policy and political concerns and investors therefore have reason for caution…but where these are addressed the potential gains are vast.”