The Evolution of Stock Markets

Company Earnings are the driver for the Fundamental Intrinsic Value of a company's share price.

PE reversion to the mean is a feature of most stock markets. Stock prices tend to move in cycles, with the PE ratio rising to over 20, then crashing before reverting to a mean of around 17.

The London Stock Exchange started in 1773 and was based on the Amsterdam Stock Exchange model for company structure and regulation.

The New York Stock Exchange (NYSE) was founded in 1792 and was based on the London Stock Exchange model.

Companies were initially listed on the exchange with limited transparency, regulation and reporting of performance. Investors were primarily looking for a Return On Investment, but speculation was rife. Insider trading and other market distortions saw share prices cycle through boom and bust during the 1800s.

After the 1929 Wall Street Crash, improved regulation, combined with major "old money" investors looking for less volatility and speculation, put more emphasis on Earnings and the Price to Earnings ratio. In other words, a return to the basics of looking at ROI from business profits (Earnings).

Since the mid-1900s, the S&P500 PE has followed a regular cycle, without reaching sky-high extremes.

NYSE and S&P500 PE Ratio Cycles

Younger stock exchanges, such as many Asian exchanges, are still going through a highly speculative phase. The Japanese stock market escalated from the 1960s until 1989 with little regard for Earnings or the PE ratio.

A crash in 1989 led many investors to realise that Nikkei stock prices were not based on fundamental values and were unsustainable. Investors went back to basics, investing according to business profits (Earnings).

Unfortunately, many Japanese companies were not very profitable, and a number collapsed after the crash. Overall, the 225 companies in the Nikkei 225 battled to restructure and focus on profits. Companies were not profitable enough for Earnings to push Nikkei prices into a long-term uptrend until around 2000.

It was not until 2004 that the Nikkei PE ratio became widely reported and applied to investing.

Nikkei 225 Price Chart

Other Asian markets experience varying levels of speculation and volatility. Each stock market index will only become stable and predictable once a large number of big companies demonstrate consistent Earnings growth over one or two decades.

Nikkei 225 PE Ratio Chart

Since 2004, the Nikkei PE ratio has shown that Japanese stocks are now following fundamental principles.