Should the History of Multiple Expansion & Contraction Be Ignored?

Executive Summary

The first chart below from Vetta-Fi illustrates the average of four separate valuation methodologies. Currently, this average is about 152% above the long-term average, which is slightly above three standard deviations from the mean. Statistically speaking, observed data falls within three standard deviations 99.7% of the time. So, currently it is in the very rare 0.3% category. Highlighting the Shiller P/E or P/E10 method, which has a long-term median of 16, one can see in the second chart, it has risen to 35. Since this chart was prepared, it has risen further to 36.5. The point being made in this missive is that ever since March 2009, investors have been paying more per dollar of earnings (multiple expansion). Historically, periods with extreme multiple expansion, such as 1929, 1965 and 2000, have been followed by periods of rapid multiple contraction. When peak valuations or multiples are reached, investors begin touting “this time is different.” The statement should be “is the risk worth the price?”

For further analysis, continue to read The Details below for more information.

“History repeats itself, but in such cunning disguise that we never detect the resemblance until the damage is done.”
–Sydney J. Harris

The Details

There are many methodologies for determining the valuation of the stock market. In my June 3, 2025, newsletter I highlighted a number of these methodologies. Valuations provide information about the reasonableness of prices, based upon some financial metric, such as earnings, revenue or market capitalization. Over a very long time period, an average (mean) and median level can be determined for comparison to current prices. When investors are full of zeal and willing to pay more for a certain level of earnings, multiples expand. In bear markets, exuberant valuations are burned off as valuation levels tend to drop below the mean.

Below is a chart from Vetta-Fi illustrating the average of four separate valuation methodologies. Currently, this average is about 152% above the long-term average. The chart breaks down the levels according to how far they are from the mean using standard deviations. The current reading is slightly above three standard deviations from the mean. For those who remember your statistics courses, in a normal distribution, observed data falls within three standard deviations 99.7% of the time. So, to rise above three standard deviations would occur less than 0.3% of the time. Said another way, it is statistically extremely rare to reach such heights.

The following chart highlights one of the four methodologies from above, the P/E10 or Shiller P/E. This was named after Robert Shiller, professor at Yale University. The P/E10 divides the current price of the S&P 500 by the inflation-adjusted 10-year average of earnings. The long-term median of the P/E10 is 16. The present reading, as of last Friday, June 13, is 36.5 or 128% above the long-term median.

The point of this missive is to highlight the fact that since the end of the last full bear market in March 2009, the increase in the S&P 500 has largely been due to multiple expansion. Or said another way, investors paying more per dollar of earnings. Human nature leads investors to push price multiples to irrational levels. During the present cycle, the Fed helped feed this exuberance by holding interest rates to near zero percent. By doing this, investors felt there was no alternative to stocks, since interest bearing accounts yielded negative real (inflation-adjusted) returns. Notice in the graph above that since 2009, except for the gyrations surrounding the pandemic years, the P/E10 has been increasing. This means investors have been continuously paying more for each dollar of S&P 500 earnings.

After extreme periods of multiple expansion, bubbles pop and multiples tend to rapidly contract. Notice in the graph above that after the 1929, 1965 and 2000 peaks, multiples plunged. Prior to the Technology Bubble, after extreme expansion periods, the subsequent bear market brought valuations down to single digits, far below the mean. Oftentimes, the index would remain undervalued for an extended period of time. The last time valuations fell to single digits on the P/E10, and remained there for any length of time, was during the mid-to late 1970’s.

Every time bubble peaks are reached, investors concoct reasons why “this time is different” and valuations will not revert back to the mean. Unfortunately for investors, the business cycle does not remain in expansion mode infinitely. Currently, even as interest rates have risen sharply and the economy is showing signs of weakness, investors remain convinced that this time will be different.

A contraction in multiples back to a single digit P/E10 would require a drop in prices of 75%. Just the math behind the numbers probably has many readers shaking their heads saying to themselves, “that will never happen” or “the Fed will never let that happen.” And maybe that is true. Maybe the Fed has figured out how to indefinitely perpetuate the business cycle.

What investors should be wondering is, at what point is the risk of loss too great? Do I want to be an investor or a speculator? If prices only reach this level relative to earnings less than 0.3% of the time, does that instill confidence? How long will the next phase, multiple contraction, last? Weeks, months, years or decades? Should history be ignored?

The S&P 500 Index closed at 5,977, down 0.4% for the week. The yield on the 10-year Treasury Note fell to 4.42%. Oil prices increased to $73 per barrel, and the national average price of gasoline according to AAA increased to $3.14 per gallon.