Is the Stock Market Overvalued Still? - P/E Ratio for the S&P500
The question on everyone's lips - Up or Down !
To answer this let's look at the PE Ratio of the Index.
One interesting statistic of a fundamental nature is the comparison of the earnings of a company compared to the stock price in the market. The Price Earnings Ratio (PE Ratio or P/E Ratio) is the Share Price / Earnings Per Share. This gives us the ability to compare companies in the same industry, or to see clearly what the expectation for a stock's performance is. A P/E of 200 is extremely high, and a P/E of 5 is relatively low. But this all needs to be taken into context. For a detailed explanation of the P/E Ratio see the lesson "Is the company in great shape".
We can also apply the PE Ratio to an entire index. Here you can see the PE Ratio for the SP500 calculated to June 2010.
A plot of the S&P 500 composite index price to earnings (P/E) ratio, and long-term interest rates in the US, from 1881 to 2008. Modeled on a plot from the book Irrational Exuberance by Robert Schiller
I heard an analyst on Bloomberg yesterday suggesting that the S&P500 P/E Ratio was about 13, and could go as low as 10, then his company would start buying blindly anything that looked cheap. I do not know where he got his information but the research on the web shows most resources saying the PE for the SP500 is just a touch under 20. It is also interesting that a major fund managers strategy is to "buy blindly". Does that give you confidence? This is why you can only trust yourself in the stock market and why we must really learn how the stock market works before investing.
A figure of 20 means that the index is not over-valued, but certainly not under-valued either. In original research in my book "The Liberated Stock Trader PRO", I suggest that 20 is a modern level at which the market seems balanced in a healthy business climate. However is the business climate healthy today? Not really.
We see that the markets have been falling quite dramatically recently and volatility is increasing showing uncertainty of the market participants. The market can certainly continue its fall, it has a long way to go to the March 2009 lows. I personally do not think it will fall that far, but we can never say never.
A P/E for the S&P above 25 is certainly dangerous territory even in a healthy business climate. You can see from the image that each time this has happened the market has seen a correction there-after.
Does the stock market have further to fall? In many cases at the moment we are in a secondary downtrend, and the markets are trading sideways until the February 2010 lows are surpassed.
When will the market turn around? We need to look for a trend change, at right now there are now signals that this is happening.
What about contrary opinion? Yes everyone seems to be very bearish at the moment, so this could indicate that the bottom is closer that we think, but this is simply opinion not hard facts.