We periodically take a look at where the SPX is in relation to its normal price to earnings range to see if prices are overvalued or undervalued. Currently, we see that values are a bit rich, but not yet at the overvalued level.
(Excerpt from recent blogs for Decision Point subscribers.)
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The charts below show the S&P 500 Index (black line) in relation to its normal P/E range. A P/E of 10 is undervalue, a P/E of 20 is overvalue, and a P/E of 15 is considered to be fair value. The first chart is very long-term, beginning in the 1920s, and we can see that prices are generally contained within the undervalue/overvalue range, but they do occasionally move outside the range, presenting rare opportunities or periods of grave danger. The unusual down spike in 2009 is the result of Q4 2009 earnings being hammered by the financial crisis, when companies took the opportunity to clean up their balance sheets with the intent of improving future earnings.
The following chart zooms in to give us better detail of the current period. With a P/E of about 18, prices are greater than the fair value line (P/E = 15), but they still are well below the overvalue line (P/E = 20). Based upon the example of the 2007 price top, prices do not have to reach the extreme top of the range before a bear market begins. The problem is that earnings have topped.
Conclusion: With a P/E of 18 the S&P 500 is still not overvalued. This does not guarantee that prices will continue to move to the top of the range, but at least bulls can say that valuations are not an issue right now. The most obvious problem is that earnings have topped, and falling earnings creates resistance to prices moving higher.
Images: Flickr (licence attribution)
About The Author
Carl Swenlin is a self-taught technical analyst, who has been involved in market analysis since 1981. A pioneer in the creation of online technical resources, he is president and founder of DecisionPoint.com, a premier technical analysis website specializing in stock market indicators, charting, and focused research reports. Mr. Swenlin is a Member of the Market Technicians Association.