Bogle: Speculative Return vs. Investment Return

John C Bogle, in his speech at The Money Show in Las Vegas, Nevada on May 15, 2006 divides the total stock market return into 2 parts:

1. Investment Return, consisting of the initial dividend yield on stocks plus their subsequent annual earnings growth, together constituting what we call “intrinsic value”; and
2. Speculative Return, reflecting the impact of changing price/earnings multiples on stock prices.

The Total Return is simply the sum of these two figures.

For example, if the P/E of a stock did not change, a 4 percent dividend yield plus earnings growth of 6 percent would give a 10 percent investment return. If the P/E rose, say, from 15 to 20 over 10 years, that 33 percent gain would add almost 3 percent per year to the return, increasing it to 13 percent. If the P/E were to decline to 12 over that same 10 years, it would reduce the returns by more than 2 percent.

According to Bogle, it really is that simple. As proof he points out that over the past 100 years the average annual total return on stocks was 9.6 percent, virtually identical to the investment return of 9.5 percent. 4.5 percent of the return was from dividend yield and 5 percent from earnings growth. Speculative return, therefore, contributed a mere 0.1 percent per year over the long haul, but it created many fluctuations in the short-term.

Bogle’s message:

. . . in the long run, stock returns depend almost entirely on the reality of the investment returns earned by business. Momentary investor perception, reflected in speculative return, proves to be an illusion that counts for little.

My question is, should P/E ratio be used to determine when to buy into the market? Or, do I buy in even when the P/E ratio is at a historical (and unsustainable) high? It would seem that the only logical time to buy is if the P/E ratio is below a certain level that would make the long term holding of the equity more profitable than holding bonds or other interest bearing assets.