Set out how valuation multiples change over the business cycle

Valuation multiples such as the price-to-earnings ratio are themselves cyclical. Near the bottom of a cycle earnings are depressed but prices already anticipate recovery, so trailing P/Es look high; near the peak earnings are unusually strong and trailing multiples look low even when prices are stretched. Beyond this denominator effect, multiples rise when real rates or risk premiums fall or long-term growth expectations improve, and fall when those move the other way. That is why analysts smooth earnings, for example with the cyclically adjusted P/E, which divides price by a ten-year average of inflation-adjusted earnings, before comparing a multiple with its history. The trap is reading a high trailing P/E in a recession as evidence that the market is expensive.