247Bull.com Editor: The S&P 500 has already surpassed the March 2000 high of 1,553 and it is now just a few points below the October 2007 all-time high of 1,576. Since the March 2009 low of 666 the index has climbed the archetypal “wall of worry” and the bears continue to point to declining volume as a sign of lower participation and thus bearish sentiment. However the bulls continue to push the index higher. One scenario is that the S&P rallies to 1,600 where it will complete a megaphone pattern on a monthly chart that could take it back down to around 1,125.
We periodically take a look at where the S&P 500 Index is in relation to its normal P/E 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.
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.
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.
Carl Swenlin | president and founder of DecisionPoint.com