Price-to-Earnings Ratios in Relation to Domestic Equity Mutual Fund Flows

Following the robust performance of the domestic equity markets in 2013, more investors are focusing on traditional valuation metrics for U.S. stocks such as the price-to-earnings (P/E) ratio for a particular index or basket of stocks. The P/E ratio is the average of a company’s share price compared to its earnings over the past four quarters. The average P/E ratio for the S&P 500 Index since 1990, using month-end data, has been 19.1 on an operating-earnings basis. For perspective, S&P’s estimate of the S&P 500 Index’s P/E ratio as of December 31, 2013, is 17.2, while at year-end 2012 the published operating-earnings P/E ratio was 14.7. With P/E valuations increasing following the S&P 500’s 2013 total return of 32.29%, it may be worthwhile to take a look at how similar trends for P/E ratios have historically been correlated with  an important source of demand for the domestic equity market–U.S. mutual fund and exchange-traded fund (ETF) flows.

During the period from the early 1990s through 2000, domestic equity fund flows (ex-ETFs) were in positive territory and were generally increasing at a significant pace on a year-over-year basis, while the P/E ratio for the S&P 500 Index was also rising steadily. Following the technology sector-driven decline in domestic equities in the early 2000s and a relatively mild recession, demand for domestic equity funds once again began to rise in 2002-2004, along with P/E ratios. Flows remained positive for domestic funds in 2004-2005 as P/E ratios flattened off. However, domestic ETF flows rose from 2005 up until the financial crisis of 2008 as P/E ratios also were increasing gradually.

In the wake of the financial crisis demand for domestic equity ETFs has increased steadily along with P/E ratios, while net positive inflows for domestic funds ex-ETFs turned positive only in 2013—for the first full calendar year of net inflows since the 2008 financial crisis.  Historical trends in fund flows do tend to illustrate that domestic fund (ex-ETF) flows tilt toward positive net flows as P/E valuations rise and do so for consecutive periods, although they were much slower to do so following the financial crisis of 2008 than in past cycles. Domestic equity ETFs have experienced positive net flows at a quicker pace post-crisis and have risen along with P/E ratios since then. The P/E ratios’ positive correlation to net domestic equity fund flows appears to have diminished in recent years, while the rate of change of PE ratios have remained fairly strong at predicting ETF domestic equity net flows.