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Stock Market Valuations are To High


To beat the market it is very important to have a good understand of the value of stocks the market is suggesting. The price earnings ratio (PE) is a useful indicator for this purpose. What is the current PE ratio of the S&P 500 telling us now and what should investors do about it?

Pattern for Earnings Growth

Ed Esterling of Crestmont Research has looked at the pattern of profit growth and declines over the last six decades. There have been three to five years of strong profit growth followed by one to two years of profit declines. Using a three-year moving average to help smooth out the short term swings gives us an interesting perspective as shown in the chart below.

As shown above earnings growth tends to oscillate around the 6.6% average earnings growth rate. Since, 2008 is likely a recession year, we can expect earnings growth to fall further, completing the pattern. As a result, expect earnings growth to fall further, possibly even becoming negative for a short time period. You can read much more about Ed's book titled Unexpected Returns: Understanding Secular Stock Market Cycles.  It is one of the best, easy-to-read, study of stock market cycles of which I know.

Outlook for 2008

Given this perspective, let us look closer to the projections for earnings growth for the rest of 2008. According to Standard & Poor’s, they are projecting earnings for the S&P 500 to be $71.20. This gives us a PE ratio of 19.2, which is significantly above the generally accepted average of 15.6, meaning market valuations are high, and likely higher than many investors expect.

One of the unwritten rules in looking at the markets is that most analysts and economists tend to be wrong in their forecasts. In fact they usually follow the market and the economy instead of lead it. Should we expect anything different this time? I do not think so. I expect further downward revisions in the earnings expectations of the S&P 500 during 2008.

Lending credence to this is the latest S&P forecast for the four quarters that end in June. They expect it to reach $65.15, which gives us a PE ratio of 20.8. This is a very high valuation, especially for a recessionary period.

So when will we see a recovery? We probably can assume that the market started its downward move in earnings in the fourth quarter of 2008. Since this type of move down can last from one to two years the earliest we will see earnings growth start to trend up will the first half of 2009. Yes, much of the global economy is still growing and does not yet seem to be affected by the U.S.’s problems. However, our problems will spill over into other countries as well.

The Bottom Line

As a result, I expect to see the current bear market to last into 2009. This means the current volatility is likely to continue. As investors, we need to remain defensive and take advantage of what the market gives us. In all bear markets, there are sectors and companies that do well for a little while. For example, agriculture products like wheat, soybeans, and corn are likely to continue to do well. This bodes well for DBA as well as companies that transport these grains to their end destination. However, this is only for a trade, not a long term hold. We can also short the market after the quick rises to resistance levels using various ETFs that short the market. It will be important to be nimble. Further, holding cash is a valid strategy while you wait for the outlook to clear.