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Tuesday, June 5, 2012

Market valuation

I often see the media talking about how cheap the market is and how that limits down side risk.  Lets take a look and see if there is any truth there.  This is a page with a snapshot of some common indexes and their P/E ratios.  It can be found here http://online.wsj.com/mdc/public/page/2_3021-peyield.html

There is a pretty big difference among the major indexes.  The Russell 2000 is actually in bubble territory.
The Nasdaq 100 is very low, but I suspect this is largely a function of the abnormally large profits from Apple.  The S&P 500 is near its long run mean.  Now lets take a look at a long term chart of the P/E ratio.

Up until 1990 the P/E ratio spent a lot of time below the mean.  We clearly went through a period of very high valuations.  If you read the piece I wrote on the debt, you would  notice the increased P/E ratio coincided with the big increase in the debt.  Now that the debt boom is over, there is a pretty high chance that the valuation will be spending much more time below the mean in the future.  You can also see that there are some pretty serious dips in valuation.  By historical standards it is clear SPX is not cheap. It is simply average.

Here is a chart that calculates the P/E ratio by averaging the earnings over 10 years to smooth out the fluctuations of the business cycle.

The mean is a little higher then in the other calculation.  I like this chart a little better. It seems to show the trend in valuation clearer.   It also shows the big spike up in valuation in the 20s that coincided with the big run up and crash in stocks during that period.  The first chart does not really show that peak valuation all that unusual.  I like the way this chart smooths out the big spike up in valuation that occurred in 2008 because of the huge losses suffered in the financial sector.  This chart has a clear down trend in valuation, but still indicates we are on the high side.

Both charts show that previous secular bear markets have ended with the ratio below 10.  A number we have yet to get anywhere near.  I guess it could be different this time, but I think the market roller coaster will continue. 

These charts along with more explanation can be found at http://www.gurufocus.com/shiller-PE.php


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The information in this blog is provided for educational purposes only and is not to be construed as investment advice.