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Is the market OVERVALUED - A look at the S&P P/E Ratio



July 06, 2010 – Comments (5) | RELATED TICKERS: SPY , DOW , N

I thought this article added to the 'bearish' points I and others made in response to Rexlove's blog about the market being undervalued based on P/E ratio.

Excerpt and link:

The Multiples Myth

I am getting tired of the endless procession of permabulls who keep insisting that. at a 13 times multiple, the S&P 500 is cheap. The last time I heard this was in 2000, when NASDAQ multiples went from 100 to 50, on their way to 10. Before that, it was in Japan in 1990, when multiples went from, guess what, 100 to 50 on their way to 10. Some 20 years later, Japanese multiples are still at 15.

When I first entered the stock business in the seventies, typical equity earnings multiples were in the seven to eight neighborhood. If you performed exhaustive stock screens, which then involved paging through endless reams of 10-k’s, newsletters, and tip sheets printed in impossibly small type, you could occasionally find something at a two multiple, the kind Graham and Dodd wrote about. Anything over ten was considered outrageously overpriced, fit only to be sold on to retail investors. This is when the prime rate was at 6%.

The selloff we saw this week is consistent with my long term view that we are permanently downshifting from a 3.9% to a 2%-2.5% growth rate, and the lower multiples this deserves. If you had any doubts, take a look at the $24.7 billion in May equity mutual fund outflows, versus the $14.2 billion sucked in by bond mutual funds. I’m convinced that if the circuit breakers had not been installed, we would have been visited by another flash crash this week...


5 Comments – Post Your Own

#1) On July 06, 2010 at 3:45 PM, binve (< 20) wrote:

JGus, I just keeping nodding my head with your posts. The biggest disconnect between bulls and bears, and why we think eachother is speaking gibberish comes down to this statement by a guy we both respect, Chris Martenson:

"The next 20 years will be completely unlike the last 20 years"

If you are a bull, you say this is BS. You look at fairly recent yield curve trends, you look at fairly recent P/Es and you apply "the rule of 20" or other "neo-analysis".

If you are a bear, you totally agree and you expand your horizon, looking back at least 70 years but more like the last 150. You don't dismiss the South Sea Bubble as an analysis point. You look at bubble valuations and what the crashes look like both from a P/E and dividedend yield perspective. You realize that most crashes have very high optimism before a Phase II crash.

To be bearish in this environment and to perform analysis on it means you are much more of a market historian. If you are bull, you rely on a "this time its different" mentality. And who knows, maybe it really is different (eventually it will be). But I put the odds on that pretty small.

BTW, as always, great tickers :)

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#2) On July 06, 2010 at 4:06 PM, Griffin416 (99.98) wrote:

I'm a recently converted bull, now bear. I'm not here dispute your blog, although I do believe that 13 P/E is low especially considering low interest rates.

My question is about forward p/e's. Going back in time, it is easy to see that a S&P p/e of 30 always precedes a crash (1929, 1987, 2000). But more importantly, at those times, what was the forward p/e? Same question applies to those single digit p/e times, like 1975, 1982, etc. Do you guys know of any chart or historical info about forward p/e's since all we hear about in the moment is forward?

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#3) On July 06, 2010 at 6:02 PM, walt373 (99.75) wrote:

I don't put much weight in historical S&P500 P/E ratios besides as a very fuzzy benchmark - if the P/E is under 10 it's probably a good time to buy, and when it's over 30 is probably a good time to sell. Anything in between is up for debate. You cannot say that the S&P is overvalued at 17 and undervalued at 13, since the circumstances are always different. There are too many factors to consider, such as inflation, economic strength, etc.

You also have secular shifts in the economy that can affect P/E. For example, as the majority of S&P500 stocks moved away from manufacturing and toward services, the E in P/E has changed. Manufacturing companies capitalize costs much more than service companies, who spend more in SG&A and R&D, which fall under operating expenses. Since cap ex does not reduce earnings, while operating expenses do, you will have a skewed view of earnings if you compare one time period to another directly. The ultimate determinant of value is free cash flow, not earnings, and service companies on average have higher FCF to earnings. So arguably, the "fair" P/E in a service economy is higher than in a manufacturing economy, all else equal. Just one example.

If you had any doubts, take a look at the $24.7 billion in May equity mutual fund outflows, versus the $14.2 billion sucked in by bond mutual funds.

Mutual fund flows are a great contrarian indicator. Seeing how the most uninformed investors in the market have been running away from stocks and into bonds for the past few years, even throughout the rally, I believe this is an advantage for stocks over bonds going forward.

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#4) On July 06, 2010 at 6:14 PM, 1315623493 wrote:

My models are predicting another 5-10% drop in the Dow. I love being a bull but I just can't be one right now. Just take a look at the bond market. Yields are super low. The 10-Year Treasury Yield is positioned 5% inside its 52 week range, while the Dow Jones is positioned 52% inside its 52 week range. This indicates to me there is a lot of room for further losses in stocks and that the probability of such losses is significantly higher than the probability of an uptrend in stocks.

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#5) On July 07, 2010 at 3:50 AM, DarthMaul09 (29.89) wrote:

I agree with binve, your beliefs have a lot to do with how you view the market.  I recall that he wrote a blog about this topic in the past.  I believe that the market will remain that elephant that everyone has an opinion on but few can comprehend the whole animal.  In terms of P/E ratios, moving averages, fundamental analysis and econmic schools of thought the real answer maybe that the market is what it is:  A massive number of input trades, manipulations, incompetence, greed, fear, hope and crimes both visable and invisable that makes up the greatest gambling parlor in the world.  And no known method of counting cards in this market can guarantee success, unless of course you happen to be JPM in the silver market.

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