Price Earnings ratio dispersion is at its lowest level in twenty five years according to a new Goldman Sachs Group Inc (NYSE:GS) report. This means that stocks with very different earnings potential are being valued at the same multiple as each other. The trend is a worrying one for the stock market and the likely perpetrator is the market’s old friend, the Federal Reserve policy.

Price Earnings Ratio

Cause of tightness in Price earnings dispersion

Value investing is another apparent cause of the increasing tightness of Price Earnings dispersion, according to the report. As QE drove up the prices of stock, investors began to look elsewhere for equities that seemed relatively valuable. That drove the value of the initially less valuable securities up, and has driven a homogenization of market valuations.

Price Earnings Ratio

P/E ratio dispersion

According to the Goldman Sachs Group Inc. (NYSE:GS) report, P/E expansion has been responsible for most of the growth in the stock market through 2013. This means that in general the stock market has been inflated because of QE. The company’s operation in the market has not increased business enough to justify the increases in valuation.

Price Earnings Ratio

Expectation for total returns

The Goldman analysts see 65 percent of the total return in the stock market this year being from P/E expansion rather than underlying value expansion. That’s a tough pill to swallow for any looking to the stock market as evidence that the U.S. economy is back on track.

P/E expansion in the United States has been driven from the bottom. Lower market cap equities, which are traditionally traded less than big cap firms, led P/E expansion through 2013 as they appeared more valuable to investors. The large amount of money pouring into these securities has caused the whole of the market’s P/E dispersion to shrink.

Price Earnings Ratio

Value investing and P/E ratios

The Goldman analysts see the importance that role value investing had in getting the market to where it is today, but that doesn’t mean that there is no value left in the current market. The analysis suggests that there is still a role for value investors in identifying companies that are undervalued by the new P/E dispersion regime.

Price Earnings Ratio

The Goldman analysts took a look at dispersion in the current market by sector and found huge differences between industries. The lowest P/E dispersion is in utilities, which is to be expected given their history, while the highest dispersion was to be found in financial stocks. The Goldman report does offer a screen to help identify value investing ideas in the new atmosphere.

Stock screening for 2013

The screen employed by the analysts involves finding peer companies in subsectors with “P/E valuation +/-5% of one another; 2014 EPS growth forecasts differ by at least 25%; and our Growth MEF scores show significantly different underlying growth metrics.”

A market in which so many companies trade for similar P/E ratios despite different earnings potential may seem like the ideal place for a value investor to look, but it seems very dependent on the attitude of the Federal Reserve over the next few months. If the bank continues pumping, the market might never get back to its older valuations.