The present value of a stock should be based on the money that you expect that stock to make in the future (in divideds etc), discounted back to the present (a dollar next year is only worth however much money I have to put into the bank now to have a dollar next year).

Since most companies tend to grow at a relatively constant rate (and most tend to track the economy), their worth is usually thought to be some multiple of the current earnings of the company, whether or not the company currently returns earnings as dividends or reinvests them in the company. (Reinvestment is fine because it means that there will be even more money whenever company dividend policy changes.) Thus the ratio between the total price of the company and current earnings is a measure of how fast the company will grow.

A common rule of thumb is that most companies tend to grow with the economy. Therefore the P/E of the market as a whole is an estimate of how the economy is expected to do. Long-term the economy tends to grow at a relatively constant rate, and that growth is what makes stocks a good investment. Stocks are literally a way to invest in our economy.

Therefore unless the economy as a whole undergoes a fundamental transformation, you would expect to see the P/E ratio remain fairly constant. But you [link|http://www.lowrisk.com/sp500pe.htm|don't]. And in fact we are still high. (Note that we are also in a recession - both stocks and earnings are way down.) So the fundamental engine of the stock market - our economy - has done well but stock values have done much better. Which suggests that stocks are still overvalued by quite a bit. But long-term if that engine holds up, so will stocks. And as far as I can tell, that engine has kept chugging along pretty well. (Even though having stocks come back to where they should be relative to that fundamental basis is likely to be painful.)

An incidental note. They like to [link|http://lowrisk.com/nasdaq-1929.htm|compare] this market to the stock market of 1929. And it is a reasonable comparison. But what they leave out of that investment picture are the impact of dividends. While the price of the Dow didn't come back for decades, had you bought a portfolio of random stocks at the start of 1929 and continuously reinvested dividends in stocks, by 1935 you were in the black, dipped briefly in 1937, improved from there and from 1944 onwards your compound annual rate of return from the start of your investment never fell below 8.5%. (Statistics quoted from page 290 of How To Buy Stocks.)

In other words it took a heck of a lot less time to recover your money after that disaster than the price figures would show.

Cheers,
Ben