Last Bastion of Higher Stock Prices Turning Negative
By Michael Lombardi, MBA for Profit Confidential
The only time-proven market indicator that said stocks were undervalued for most of 2010 and 2011 is turning negative.
The Price/Earnings (P/E) ratio takes the current market price of a stock or index and divides it by the earnings of that stock or index.
Historically, P/E ratios between five and 10 are considered undervalued and indicate a good time to invest in stocks, with the thesis being that corporate earnings have bottomed. When the range is 10 to17, the companies/indices are considered at fair value by most stock market analysts; 18-25 is overvalued; with anything above 25 being considered a bubble (the S&P 500 was well above 25 during the tech bubble of 1997 to 1999).
Personally, given the low-interest-rate environment of today, I see stocks as a bargain if the P/E ratio is between 10 and 12 and corporate earnings are not nose-diving.
It is said that the stock market is the most efficient valuation tool in the world for valuing companies. In 2010, the stock market knew 2011 would be a great year for corporate earnings, hence stock prices moved higher in anticipation of higher corporate earnings.
Even with the latest rise in the stock market, the S&P 500’s current P/E ratio stands at 15.13, while the Dow Jones Industrials’ P/E comes in at 13.77. This would be considered fairly valued.
Some would make the case that any upside surprise in the U.S. economy would result in strong corporate earnings, which would move such a fairly valued market much higher.
The problem with this rationale is the “E” in the P/E—corporate earnings per share. I noted just yesterday how blue-chip companies in the S&P 500 and abroad are struggling in this environment. Over the past month, I’ve been talking about how the recession in the eurozone is causing growth to slow sharply in both Asia and the U.S. (See: Half of the Eurozone Downgraded: Time to Start Worrying.)
In the U.S., this slow growth environment (which I believe could become a recession) means corporate earnings are going to come under extreme pressure. Already, companies are blaming the difficult global economic environment for their lowered 2012 corporate earnings forecasts.
I have a feeling that P/E ratios for both the S&P 500 and the Dow may challenge the undervalued levels closer to 12 or even 11 in 2012, as disappointing quarterly corporate earnings begin to pour in. The market may be undervalued at that point, but I don’t believe the market will perform well in such an environment.
Dear reader, at these fairly valued P/E levels, the S&P 500 and the Dow Jones Industrial Average do not look attractive. If you want to jump into …





