The S&P500 gave back a minor 1% last week. Volume was light. Volatility jumped 12%, but was still hovering near multi-year lows. The equity market is still extremely over-bullish. According to the Investors Intelligence Sentiment Poll, about 55% of advisers are bullish, while only 19% of them are bearish. This is extreme. In fact, the difference between the two (bullish less bearish) is at the highest level since the market highs of 2007.
US economic activity continues to struggle to gain traction. The Chicago Fed National Activity Index, one of the most important LEADING indicators of economic health fell again last month, this time into even deeper negative territory. Existing home sales missed expectations, while new home sales beat. Initial jobless claims just beat their expectations. Finally, durable goods orders, ex-autos, beat consensus estimates last month, but he year-over-year trend is still unmistakably weakening.
The technical picture for the S&P has not changed. The equity market is extremely over-bought, by almost any commonly used technical measure. Does this mean that the market cannot get even more over-bought? Of course not. But the risks of a pull-back are considerably higher when the markets are as stretched, technically, as they are today.
Over last several months, a commonly heard theme—especially one advertised on mainstream media outlets—is that the stock market is fairly valued. Earnings are strong. Balance sheets are full of cash, and companies are healthy and growing. And most importantly, the price to earnings ratio for the S&P is fair, implying that the stock market is not expensive.
Hence, it’s a good time to buy stocks.
But there is a very serious problem that’s being overlooked with the “P/E is fair” argument.
First, and less important, is the fact that the current P/E, according to the Market Data Center in the Wall Street Journal, is already over 19x. A year ago, it was under 15. And the 100+ year imputed median P/E for the S&P is only 14.50. So on this basis alone, the S&P500 today is not cheap. Arguably it’s about 25% (19 divided by 15) over priced.
Second, and more important, let’s examine the “E” or the earnings in this P/E ratio. Where are earnings, of the S&P500 as a whole, in relation to their historical averages? It turns out that S&P earnings are off the charts, literally. As a percentage of the US GDP, they have reached almost 11%. Where should they be….historically? Closer to 6%. That means that earnings are now over 70% ABOVE their long-term historical average, which means that IF earnings revert back to this level—-and historically they ALWAYS have—then the S&P500 is about 70% over priced.
And that’s assuming we accept the elevated 19 P/E ratio!
So the next time you hear someone bleating about how fairly priced the S&P500 is today, think about what they’re really saying, whether they realize it or not. They are claiming that earnings that are 70% above normal will continue to be generated almost forever into the future.