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S&P Reaches New High

spx-overvalued-pe1

As a follow up to yesterday’s post, today the S&P 500 Index made a new All Time High.

To put this in perspective, last Spring estimates of 2015 earnings for the S&P 500 were $137 but today it is $119.

Historically, falling earnings has meant falling stock prices – makes sense doesn’t it? If a company’s or group of companies’ earnings projections fall 13%, you’d expect the stock to fall as a consequence because it is inherently worth less than previously expected. However, we are experiencing a new paradigm – we have a never-before-seen liquidity flood flowing into the investment markets that is driving prices higher in spite of growing P/E ratios.

If you look at the graph above, you see a solid purple line. This represents the S&P 500 index for the past 20 years. You also have red, blue and green lines that represent the P/E levels over time for 20X S&P 500 earnings (an overvalued level of the market), 15X S&P 500 earnings (a fairly valued level of the market), and 10X S&P 500 earnings (an undervalued level of the market).

It is fairly easy to see that the purple line is about to intersect with the red line – or in other words, the S&P 500 is overvalued at 20X earnings.

But what else do you see? There have been many times times in the past 20 years where the market has traded at 20X valuation or even far surpassed the 20X valuation. However, it has always resulted in a fairly major correction at some point.

Is this a useful graph? To me it is. It helps me maintain perspective on valuations, particularly in the face of falling earnings estimates. Its just another tool I use to help me decide on buy and sell decisions in portfolio management. Earnings and stock price are naturally connected and eventually when the flood of liquidity ends (remember the Fed saying that they would raise rates this year?) the likely trajectory of the stock market is to realign with earnings and fair value and that gaping hole called reality will finally return to the investment markets. Right now this indicator and the fundamentals are telling me that the market is at a dangerous level and caution should be the word of the day.

Have a great weekend!

Mark